Republic of Estonia: 2019 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Republic of Estonia
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International Monetary Fund. European Dept.
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Publication Date:
22 Jan 2020
eISBN:
9781513526881
Language:
English
Keywords:
ISCR; CR; government; GDP; State budget; CFT regime; stability authorities; pay; economic activity; fiscal policy; state task; wage pressure; data provision; state's possibility; liability positions vis-à-vis nonresident; Anti-money laundering and combating the financing of terrorism (AML/CFT); Wages; Financial derivatives; Pension spending; Global; Baltics; wage growth; core inflation; growth remain; public sector wage development; potential GDP; IMF staff calculation; IMF staff estimate
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2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Estonia

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Estonia

Context

1. Macroeconomic performance remains solid. GDP growth has exceeded potential over the last three years, supported by strong consumer confidence, with unemployment falling and wages rising. On the back of the strong economic activity, actual revenues have outperformed the budget. However, while the business environment remains favorable, recent AM L/C FT allegations and problems with the insolvency framework need to be addressed. The authorities have undertaken several policy initiatives, including making the second pillar of the pension system voluntary. Since the last Article IV, the authorities have taken measures to enhance macroprudential policies, closely in line with staff’s recommendations, but the expansionary fiscal stance of the last few years has yet to be unwound (Annex I).

Recent Economic Developments

2. Economic performance has been favorable, although growth is slowing modestly. Real GDP growth eased in 2018 (Table 1, text figure 1),1 but remained robust and above potential. The strong activity was driven by private consumption—supported by rising employment and wages— and growing investment. The contribution of net exports was negative owing to decelerating external demand in main trading partners following trade tensions; import growth continues to outpace that of exports.

Table 1.

Estonia: Selected Macroeconomic and Social Indicators, 2016–24

(Units as indicated)

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

Statistics Estonia revised National Accounts series in August 2019 inter alia shifting reference year to 2015 and improving the methodology.

Includes trade credits.

Net of portfolio assets (including money market instruments, financial derivative assets,

Includes the Stabilization Reserve Fund (SRF).

Text Figure 1.
Text Figure 1.

Growth and Inflation

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

3. Economic expansion has eased further in 2019. The deceleration reflects a slowdown in the construction sector, one of the main drivers of growth over the previous years; the energy sector’s disruptive transition toward carbon neutrality; and lower exports due to the impact of international trade tensions. The energy sector, representing a sizeable part of GDP, is undergoing significant transition from oil shale to renewable energy production. The recent rise in CO2 prices has slowed significantly the performance of oil shale-based electricity production (Annex II). Inflation decelerated to an average of 2.4 percent during the ten months of 2019 from 3.4 percent in 2018 owing to lower energy prices (Table 1, text figure 1). Core inflation has averaged 2 percent over the first half of the year.

4. The labor market remains tight. The unemployment rate fell to 3.9 percent in 2019Q3, with a stronger labor force participation rate at 72 percent, helped by the work ability reform and integration of migrant workers. Gross wages were up by 8.9 percent in 2018 and their growth eased only to 8.1 percent on an annual basis during 2019Q3, as the labor market remains tight. But the wage growth continues to exceed productivity growth, constrained by limited investment in research and development (R&D) and other structural factors.

Text Figure 2.
Text Figure 2.

Wages and Employment

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

5. The fiscal stance has been accommodative, but debt is low. The budget shifted into a deficit during 2017–18 (Text figure 3) that exceeded the allowable limit of 0.5 percent of GDP under domestic fiscal rule. This outturn was driven by increased salaries for priority occupations,2 higher-than-programed public investments and transfers to households. Despite strong revenue collection, the general government recorded a deficit for 2019H1, owing to increases in health and education spending. Nevertheless, gross public debt stands at just 8 percent of GDP.

Text Figure 3.
Text Figure 3.

Fiscal and Current Account Balances

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

6. The current account (CA) surplus narrowed, but the external position is assessed to be substantially stronger than justified by fundamentals:

  • The CA surplus decreased to 1.7 percent of GDP in 2018, from 3.2 percent a year earlier (Text figure 3), mostly reflecting steady growth in domestic demand that outpaced strong export performance. The surplus continued to narrow in 2019H1 owing to sustained internal demand and moderating foreign demand on the back of an uncertain global environment marked by trade tensions. While there is no evidence of weakened competitiveness in the CPI-based REER, the value-added-based REER—which accounts for the fact that much of Estonia’s output comes as one stage in complex global value-added chains (GVCs)—suggests some loss of competitiveness over the last decade (Text figure 4, SIP: “Competitiveness and GVCs).

  • The external position is assessed to be substantially stronger than justified by medium-term fundamentals and desirable policies, with an estimated CA gap of 4.3 percent of GDP (Annex III). This assessment considers structural changes, but policies, notably Estonia’s strong fiscal position, have contributed as well. The policy gap is estimated at 2.2 percent of GDP, reflecting mostly the need for more cost-effective public health spending amid unfavorable demographics.

Text Figure 4.
Text Figure 4.

Price Competitiveness and Non-Resident Deposits

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

7. Financial soundness indicators suggest that the banking system remains strong, despite concerns about AML/CFT developments:

  • Financial soundness indicators (Table 8) suggest that the banking system remains healthy. The growth of bank lending and leasing combined for non-financial corporations and households eased to 5 percent (y/y) in October 2019 from 7.1 percent in June 2019. Lending standards remain tight and may reflect on-going concerns about the insolvency regime’s problems.3 The average interest rate, though low in absolute terms, is high compared to that of peers, as interest margins are wider due to official operations, but also low competition.

  • Despite progress in implementing AML/CFT international standards, recent allegations of money laundering led the authorities to close the branch of Danske bank. However, the impact of this closure is expected to be minimal on the banking system’s financial stability. Also the bank had sharply streamlined their non-resident operations (Text figure 4). Swedish and Estonian supervisors have recently launched an AML investigation of Swedbank, whose subsidiary is the second largest bank operating in Estonia (28.7 percent in asset share).

Table 2.

Estonia: Summary of General Government Operations, 2016–24

(In percent of GDP)

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

Estonia: General Government Financial Assets and Liabilities, 2012–19:Q2

(In millions of euros)

article image
Source: Statistics Estonia.

Including commitments under the European Financial Stability Fund.

Table 4.

Estonia: Summary Balance of Payments, 2016–24

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

Excluding interest payments and reinvested earnings.

Includes operations in debt securities.

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, other investment assets, and reserve assets held by Estonian residents.

Includes government guaranteed debt.

Table 5.

Estonia: Macroeconomic Framework, 2016–24

(Percent of GDP, unless otherwise indicated)

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

Staff will follow-up on the progress related to the improvement in GDP data.

Public savings minus public investment differs from the fiscal balance by the amount of capital transfers received from abroad.

Mainly EU capital grants, all of which are channelled through the budget.

Table 6.

Estonia: Indicators of External Vulnerability, 2011–18

(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.

Loans and leases to households and non-financial corporations.

External debt includes money market instruments and financial derivatives.

Net of portfolio assets (including money market instruments), financial derivative assets, other investment assets, and reserve assets held by residents.

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.

Table 7.

Estonia: Households, Financial Assets, and Liabilities, 2011–18

(In millions of euros)

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Sources: Eesti Pank; and Statistics Estonia.
Table 8.

Estonia: Financial Soundness Indicators, 2011–19:Q2

(Percent of GDP)

article image
Sources: Eesti Pank; and Financial Supervisory Authority.

8. Real estate market activity has moderated, and prices remained anchored to incomes. Transactions in the housing market slowed by 1.6 percent (y/y) in 2018, compared to an increase of 8.2 percent the previous year. House prices increased by 5.7 percent in 2018, driven by the rising share of new houses (Text figure 5). Furthermore, the ratio of total liabilities to gross wages and salaries declined further from 114 percent in 2017 to 109 percent last year, suggesting a continued reduction in household leverage. Overall price trends remain strong, but aligned to income growth. During 2019H1, there were similar transactions overall compared to 2018H1, but fewer transactions for new apartments. The average price increased by 5.9 percent as new dwellings are being added at a slower pace.

Text Figure 5.
Text Figure 5.

Real Estate Developments

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Outlook and Risks

9. The near-term outlook is favorable, but economic activity is expected to moderate in the medium-term.

  • Real GDP growth is projected at 4 percent in 2019 (Table 1) supported by strong domestic demand on the back of a continued tight labor market. Inflation is expected to moderate due to lower energy prices. The tight labor market and wage pressures would continue to put upward pressure on inflation in the near term. Unfavorable global developments are expected to weigh on consumer confidence and the growth outlook.

  • Over the medium term (2020–24) actual and potential GDP growth are projected to converge gradually to 2.8 percent, constrained by the level of productivity. The CA surplus would continue to decline toward its norm, turning negative by 2024 due to strong import growth and weak foreign demand.

10. External and domestic risks are tilted to the downside both from potential external shocks and domestic developments.

  • On the external side:

  • Escalating and unpredictable international trade barriers could prove more disruptive to global trade and growth than currently envisaged. Weaker growth in European partners could weigh on Estonian domestic investment, adversely affecting growth (SIP: “Competitiveness and GVCs).4

  • Tightening financial conditions in Nordic economies and banking groups could pass through to the Estonian banking system, affecting lending volumes.

  • On the domestic front, downside risks include the following : (i) continued labor shortages in the highly-skilled segment and potentially intensifying wage pressures, which could affect medium-term competitiveness; (ii) continued strong economic activity, which could accelerate the rise in housing prices and increase banks’ vulnerability to the real estate sector; (iii) continued AML/CFT concerns, which could increase market pressure on the banking system; and (iv) policy implementation risks, such as delays in key reforms, for example due to the need to achieve policy consensus.

  • Against this backdrop of risks, Estonia’s substantial fiscal space, CA surplus, and strong macroprudential framework provide levers to opt for a more gradual adjustment path, if needed.

Authorities’ Views

11. The authorities broadly concurred with staff’s views on the positive macroeconomic outlook and related risks. They project the solid economic expansion to slow amid weak external demand. They agreed that productivity growth has lagged wage growth, and the gap could be even larger as current estimates do not consider the growing contribution of short-term foreign labor. They shared staff analysis that accounting for GVCs could lead to a faster appreciation of the real effective exchange rate, but considered that the CA surplus does not reflect domestic policy-related distortions. Instead, they believe it stems from the correction in the dynamics of the stock of net international investment from an initially largely negative position. They are concerned that if risks from trade tensions materialize into weaker growth in major trading partners, there could be adverse spillovers onto Estonian banks. They shared the view that domestic risks are to the downside given AML/CFT concerns.

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 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 between 30 and 50 percent). 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. “Short term” and “medium term” are meant to indicate that the risk could materialize within 1 year and 3 years, respectively.

Policies for Boosting and Sustaining Growth

12. Estonia faces a conflict between the contractionary policies that would address domestic imbalances and the expansionary policies that would resolve external ones, but the substantial fiscal space gives the authorities scope to adopt a longer-term approach. With a positive output gap there is a clear case for unwinding the current expansionary fiscal policies. At the same time, an appreciation of the real effective exchange rate would be necessary to restore external balance. While the authorities have a clear preference for an upfront tightening of fiscal policy, with no net debt Estonia has scope to reorient fiscal policy in a more growth-friendly direction without the need for a sizable consolidation in the near term. The monetary policy stance is likely to remain expansionary for Estonia and could contribute to domestic demand pressures and the potential for financial imbalances. Against this backdrop, macroprudential policy should help contain financial sector risks that could arise from the low interest rate environment. Going forward, the challenges are threefold:

  • gradually unwinding the positive fiscal impulse, while supporting productivity-enhancing investments;

  • accelerating structural reforms to raise productivity and reduce inequality.

  • strengthening the AML/CFT and macroprudential frameworks, along with cross-border supervision.

A. Fiscal Policy: Moving to More Growth Friendly Reforms

13. The government revised the medium-term budget strategy (MTBS). The fiscal path is contingent on the implementation of the new financial requirement framework of the European Union (EU) from 2021 onwards. The MTBS (2020–23) aims to reach a balanced structural position by 2022. Additional revenue is being earmarked from high volumes of dividends incentivized by a lowering of the corporate income tax on regularly-distributed dividends from 20 percent to 14 percent. Expenditure increases are being envisaged mainly for infrastructure investment. The government debt burden is expected to reach 6 percent by the end of 2023.

14. Under this strategy, the draft 2020 budget aimed at a slight headline deficit of 0.1 percent of GDP. The budget has been presented under a performance-based budgeting framework aimed at improving accountability and transparency across ministries and agencies. The overall spending level is constrained by previous general government budget deficits. Against this backdrop the draft budget appropriately envisages a general government structural deficit of 0.7 percent of GDP, a half percentage point improvement over last year. Under the government’s commitment not to introduce new taxes, a limited number of revenues and spending measures support the budget:

  • The planned rise of tobacco excise duty by 10 percent was replaced by a more modest 5 percent increase per year for 2020–22.

  • The anticipated expenditure measures include (i) additional wage increase of 2.5 percent for priority occupations (teachers, internal security, cultural and social workers); and (ii) an increase of the old age pension by €45 of which €7 is an extraordinary increase.

  • Staff’s projects a structural deficit of 0.6 percent of GDP in 2020, close to that of the authorities. But staff expect wages to be higher compared to the budget (0.3 percent of GDP), but will be offset by higher personal income, social contribution, and VAT taxes (0.2 percent, 0.1 percent, and 0.1 percent of GDP respectively). In line with the authorities, public investments increase in nominal terms, but decline relative to income.

15. Prudent public finance policy and low debt have resulted in substantial fiscal space. Gross debt remains the lowest in the EU—8 percent of GDP—and is fully matched by fiscal reserves, meaning that net debt is zero. Debt is projected to decline further under the baseline and stress scenarios and debt burden indicators remain below corresponding benchmarks. If negative shocks materialize, the authorities should let automatic stabilizers operate fully. Also, in a case of a severe economic downturn, policymakers could consider an expansionary fiscal policy, without jeopardizing debt sustainability. There are no major external debt sustainability concerns (Annex IV).

16. Fiscal policy should unwind, in the short term, the positive fiscal stance. With the economy operating above potential in a low interest rate environment, staff advises to unwind some of the fiscal impulse estimated at an aggregated 1.3 percent of GDP during 2017–19. This should be achieved by accelerating savings from recurrent expenditure rather than by deferring public investment projects, as the government now plans. Some of the anticipated savings could be earmarked for enhancing innovation policies by more spending on R&D in the short term—currently below the target of 1 percent of GDP—education and health.

17. Over the medium-to-long term, fiscal policy should support growth with productivity-enhancement investments. With the fiscal position above the medium-term objective of a deficit limit of 0.5 percent of GDP, there will be sizeable scope for using the substantial fiscal space over the medium and long term. On the spending side, despite progress in recent years, staff recommends more productivity-enhancing investments, high-quality structural policies (work ability reforms, active labor market policies (ALMPs), pensions and health) that would increase potential output. In addition, more investment in R&D that would bolster incentives for innovation. On the tax side, staff urges for further enhancement to support labor supply, particularly among low-income households, and to reduce inequality significantly. In this context, staff’s medium-term projections, compared to the authorities’ MTBS, anticipate a slightly more expansionary fiscal stance that takes advantage of the strong fiscal and external positions to support productivity growth and external rebalancing. This medium-term fiscal stance would not pose sustainability concerns, but would allow the authorities to comfortably support on-going reforms.

18. Public sector wage developments should be anchored by fundamentals. A general wage increase is approved in the budget, but line ministries have the leeway to reallocate resources to wages by saving from other lines. This has led to public wage growth exceeding consistently the budgeted increase (as well as private sector wage growth). The need to realign wages for priority occupations has also been a large contributing factor to wage growth. Staff acknowledges that there should be enough room for an adequate wage adjustment for income convergence with Western Europe. However, persistent divergence5 between wage growth and productivity growth could over time impact adversely competitiveness. While private sector minimum wages are the outcome of negotiations between trade unions and employers, public sector wages have an important demonstration effect. It is therefore important that public sector wage growth remain anchored to productivity growth in the broader economy.

19. The government’s agenda to improve public investment management (PIM) is welcome and should be strengthened. The PIM framework is strong, but the assessment exercise done in 2018 noted scope to improve on planning and allocation of resources. However limited progress has been made in implementing the PIMA recommendations (Annex V). Improving PIM has become more urgent as budgetary constraints are calling for efforts to tap into alternative sources of financing, including public private partnerships. In that context, staff recommended broadening the terms of reference of the new working group on PPPs to include following up of the PIMA recommendations, while ensuring that the committee be adequately staffed. To improve fiscal management and accountability, the authorities and staff discussed the possibility of conducting a fiscal transparency exercise.

Authorities’ Views

20. There was broad agreement on the policy mix and the need to follow up on the PIMA recommendations. The authorities noted that their policy priorities entail more cost-effective spending on infrastructure and pensions. They however highlighted that meeting these priorities is being complicated by the recently accumulated fiscal deficit. They concurred with staff that the current monetary policy environment is expansionary for Estonia. In this context, with a positive output gap, there was consensus for unwinding the expansionary fiscal stance. Over the medium term, it was agreed that part of the substantial fiscal space should be used to contribute to raising potential growth, by spending more efficiently and effectively on R&D, health, education, and infrastructure. The central bank however cautioned against the risk of drawing on the fiscal space for short-term and poorly evaluated and vetted projects. On PIMA implementation the ministry of finance welcomed the proposal to broaden the TORs of the PPP committee to cover PIMA implementation.

B. Long-Term Fiscal Costs and Pension Policy: Preserving Viability and Sustainability

21. Projected demographic changes would entail additional fiscal costs. The total population is expected to decline by 5 percent by 2030 and 13 percent by 2050 (Text figure 6). Under current policies, fiscal costs related to pensions and healthcare are accordingly projected to rise by nearly 3.2 percentage points of GDP on average for 2015–50 (Annex VI). While the current pension system is fiscally sustainable, this largely reflects its relatively low replacement rates, which in turn generate concerns about its social viability: poverty among the elderly is already quite high, and will grow along with the aged population in absolute terms under current policies. Bringing the replacement rate from its current average of nearly 24 percent to the minimum level of 40 percent recommended by international standards would increase fiscal costs, on annual average, by 4.8 percentage points during 2019–50.

Text Figure 6.
Text Figure 6.

Macroeconomic Impact of Demographic Changes

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

22. The situation is further complicated by prospective changes to the second pillar of the pension system. Introduced in 2002, the mandatory pillar II acts as a supplement to the publicly managed and compulsory pillar I system. Currently the system has about €5 billion (15 percent of GDP) in savings, and 83 percent of the funds are invested abroad. However, reflecting partly the global interest rate environment net returns have been relatively low, with relatively high (though declining) management fees (Text figure 7). Against the backdrop of public discontent about low returns, the proposed changes to the pillar II system aim at providing greater individual choice in investment options and making participation voluntary. The changes also introduce an option for lumpsum withdrawal of benefits or receiving an annuity from the pension fund or an insurance company.

Text Figure 7.
Text Figure 7.

Developments in the Second Pillar Pension System

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

23. Staff see more scope to maintain the pillar II pension system as mandatory while tackling its perceived shortcomings. Allowing individuals to opt out of the system or to withdraw their investment earlier would lead to lower retirement incomes and higher old-age poverty, with an increased burden for the budget. During a 1-Day Workshop jointly organized by the central bank and the Fund6, staff also highlighted other considerations to be factored into the review process: (i) given the size of the pillar II savings, injecting into the economy a sizeable amount of cash from pensions could potentially support activity in the short term, but also could be source of macroeconomic volatility; (ii) the still-developing saving culture makes it critical to safeguard the complementary role played by pillar II in capital market formation; and (iii) a significant decline of the participation rate in pillar II could lead to an erosion of the funded pension business and possibly translate into higher costs for those retaining their accounts. In that context, staff recommended to keep the pillar II mandatory. It also suggested that the authorities explore options to boost net returns for savers by better leveraging technology to reduce administrative costs.

Authorities’ Views

24. There was consensus on the need to review the pension system, but views were mixed on making pillar II voluntary. On the one hand, the ministry of finance indicated that government would continue to support the process for making pillar II voluntary as this feature is central to the political mandate of the current coalition. It was reiterated that it was important to increase freedom of choice when making pension-related decisions. On the other hand, the central bank is of the view that pillar II savings will grow satisfactorily in line with the need for a sustainable pension system, but allowing participants to withdraw cash for consumption purposes could lead to destabilizing macroeconomic effects.

C. Structural Reforms: Accelerating Productivity Growth

With ample fiscal reserves, there is still opportunity to accelerate ongoing reforms.

25. Demographic challenges call for a sustained policy focus on raising productivity. Thanks to reforms and strong economic activity, employment and labor force participation rates have increased, while unemployment has dropped to record-low levels. However, unit labor costs increased by 9.5 percent in 2018 and are much higher than in EU peers, raising concerns about medium-term competitiveness (Text figure 8). Productivity growth has remained weak since the global financial crisis. Moreover, population ageing, through a decline in the workforce and productivity, is projected to cut long-term growth in half by 2050 and further constrain labor supply. These adverse demographics make increasing labor supply critical for long-term growth. A simulation of projected changes in the composition of the work force confirms that ageing could potentially lower productivity annually by 0.1 percentage points on average over 2019–50 (Annex VI).

Text Figure 8.
Text Figure 8.

Unit Labor Costs and Population Trends

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

26. Improved integration of innovation programs and enhanced oversight could contribute to improve productivity. Estonia has made progress in the design of programs aimed at enhancing productivity and innovation. Among others, the “Estonia 2020” reform strategy helped to strengthen the alignment of education system outcomes with needed skills, and to better articulate life-long learning and vocational education. However, the economy continues to be dominated by low and medium technology sectors which yield low productivity (Text figure 9). Despite closer oversight by the Research and Development Council (RDC) in the Prime Minister’s Office, public spending on R&D remains constrained. The combined public and private investment in R&D is short of the Europe 2020 strategy target of 3 percent of GDP that was adopted by Estonia. Further, human capital needs and innovation have yet to be fully integrated into the R&D strategy. Enterprise Estonia has made progress in promoting startups, but its activity could better encompass the intensification of innovative programs. Therefore, there is a need to assess the effectiveness of the RDC and to take corrective measures, if needed.

Text Figure 9.
Text Figure 9.

Employment and the Work Ability Reforms

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

27. Other policies to boost labor supply could also help to raise long-term output:

  • Work ability reforms. Since coming on stream in 2016, these reforms are bringing a significant number of inactive individuals into the labor market with employment rates increasing among them from 33.1 percent in 2010 to 51.5 percent in 2019 (text figure 9). Participation in training remains to be strengthened and more investment is called for skill enhancements.

  • Streamlining unemployment benefits. The social protection system7 has relatively low coverage— only 33 percent of newly registered unemployed people receive unemployment insurance benefits and 26 percent receive unemployment allowance—and replacement rates of unemployment benefits are equally low—benefits are guaranteed up to only 360 days. Against this backdrop, staff strongly supports on-going work reviewing eligibility, enhancing flexibility of the system by allowing temporal employment, and making the duration of benefits shorter in good times and prolonging access during recessions.

  • Integrating more foreigners into the labor market by further reducing constraints to migration. The Aliens Acts was amended in 2018 to exempt top specialists8 from the immigration quota. Further, short-term employment of foreign employees is now permissible for 12 months compared to 9 months previously. But the immigration quota, which applies to nationals of non-EU and non-EEA countries, remains at 0.1 percent of the population per year.

28. Modernizing the insolvency framework by updating the legislation will be key. According to estimates, insolvency proceedings take around three years (1.7 years for OECD) and the recovery rate is barely 36.1 percent for fully secured credit (versus 70.2 percent on average for the OECD).9 Similarly, the debt restructuring framework is weakened by the inability of creditors to take action and by the lack of priority to new financing (text figure 10). The slow restructuring process traps real and financial capital that could have been released for productive purposes. In line with the European Directive on Restructuring and Insolvency,10 the authorities are drafting a new bankruptcy law that incorporates several innovations: proposing specialized judiciary accords; creating an insolvency service; discharging debt within a reasonable time; and transposition of the EU directive to align with both bankruptcy and pre-insolvency procedures.

Text Figure 10.
Text Figure 10.

Insolvency Regime and the Gender Pay Gap

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Authorities’ Views

29. The authorities agreed on the importance of boosting productivity. They concurred that more could be done in terms of R&D expenditure, but noted that while it has stagnated relative to GDP (owing to the rise in GDP), absolute levels of R&D spending have increased. They took note of the recommendation to strengthen the oversight of the RDC and their view was that budgetary constraints were slowing progress to achieve the target of upscaling spending on R&D to 1 percent of GDP. They see potential advantages in investing more in training and upskilling of inactive workers and remain on course to streamline unemployment insurance benefits. They agreed with the need to modernize the insolvency framework and see no major hurdles to adopt the EU directive.

D. Inequality and Relative Poverty: Supporting Inclusive Growth

30. Despite progress over the last decade, income inequality and relative poverty remain elevated. (SIP: “The Dimension of Inequality in Estonia”). During the last five years, income inequality has been declining, although it is still above the EU average.11 The relative poverty rate12 was also among the highest in Europe in 2017. A pervasive and elevated gender pay gap (GPG) puts women at a high degree of vulnerability (text figure 10) and elderly poverty is also relatively high.13 Real median equivalized disposable income has increased over the last decade for all age groups, but the proportion of the elderly that are at risk of poverty, doubled between 2007 and 2017, reaching 32 percent. Differences in economic sector, economic status, age cohorts, education, the county of residence and gender have been important drivers of income inequality in Estonia.14

31. Policies to address inequality should seek to preserve the strong gains in labor force participation and employment of the past few years. Continued reductions of the labor tax wedge on low-income households and secondary earners, like in the 2018 labor tax reform (Annex VII), would bring stronger incentives for labor force participation. Estonia’s female labor participation is estimated at 78.9 percent in 2019Q2, among the highest rates in Europe. Staff pushed for extending the availability of child care, specifically for children up to 3 years, which would provide greater opportunities for women to pursue full-time employment and help reduce the GPG. Further extending the pay transparency to other sectors in addition to the public sector would also be a significant step in GPG reduction. A stronger social safety net for the older population would also reduce income inequality. Raising property taxes would also provide scope to reduce inequality.

Authorities’ Views

32. Authorities broadly agreed with the staff’s assessment of inequality and relative poverty. While absolute poverty has fallen since the crisis thanks to increases in family benefits and the minimum wage, the relative weight of the elderly among the poor has grown as pensions have failed to keep pace with wages. They also highlighted the regional aspect of inequality and further indicated that more unemployed people are also at a high risk of poverty because of a less generous unemployment benefit system. Regarding the GPG, authorities stressed that national data with a broader coverage suggest that significant progress has been made toward the 2023 target, but agreed that more work needs to be done to reduce GPG.

E. Macrofinancial and AML/CFT Developments: Safeguarding Stability

33. The banking system is profitable, liquid, and solvent. Banks have remained profitable, reflecting cost efficiency and market concentration. Non-performing loans have been low. Liquidity coverage ratios are above the regulatory minimum requirements and banks have ample capital buffers. Strong wage growth is supporting demand for household loans, which despite strong output growth have remained steady at just below 40 percent of GDP. A crisis management simulation for eight Nordic-Baltic countries conducted in January 2019 underscored the need for enhanced coordination among agencies and for improved communication among home and host authorities.

34. Macroprudential policies are appropriate and risks are contained, but continued monitoring is warranted. Mortgage lending activity remains conservative—the average loan-to-value ratio is 74 percent, below the limit of 85 percent; the average debt-service ratio is 10 percentage points below the ceiling of 50 percent; and maturity rates average 25 years, below the limit of 30 years15. Housing prices levels are anchored with fundamentals (text figure 11). More recently however risk weights used in the computation of capital requirements for two systemic banks that use internal ratings-based models—and which account for 80 percent of housing loans— have declined from 18 percent in 2014 to 13 percent in 2019. The decline in risk weights does not seem to be mirrored in a decline in the risks associated with housing loans (Text figure 11). In response, the central bank introduced an average risk weight of 15 percent for mortgage loans that applies to these two banks. In line with credit and nominal output developments, and the credit gap, the countercyclical capital buffer is appropriately set at zero.

Text Figure 11.
Text Figure 11.

Macroprudential Developments

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

35. The AML/CFT regime has improved, amid increased international scrutiny (SIP: “AML/CFT Supervision”). Cases involving banks operating in Estonia have drawn scrutiny and affected the reputation of the financial sector. In this context, the Estonian Financial Supervisory Authority (EFSA) has continued to refine its extensive off-site supervision, conduct full-scope on-site inspections, and actively employ its powers, including precepts and license withdrawals, to enforce financial institutions’ compliance with their AML/CFT-related obligations. More broadly, the AML/CFT maximum fine has been increased, and additional resources devoted to countering illicit finance. Also, the EFSA issued extensive guidelines to supervised entities, conducted an in-depth review of bank risk profiles and initiated preparation of a new ML/TF national risk assessment.

36. Continued reform, including of AML/CFT supervision, will be critical to mitigate evolving risks. The process to impose monetary penalties for AML/CFT violations should be streamlined, and the maximum penalty further increased. The number of financial institutions that may be covered by inspections each year should be increased by introducing risk-based targeted and thematic AML/CFT inspections and/or further increasing supervisory resources. The recently-approved Center for Strategic Analysis should be created expeditiously and fully operationalized, with adequate capacity. Finally, government should hold internal discussions on consolidating AML/CFT supervision at the EU or Nordic-Baltic levels and arrive at a formal position. The AML/CFT regime is scheduled to undergo an assessment by MONEYVAL16 in 2021. Potential impact of AML/CFT risks on the macroeconomy is yet to be quantified.

Authorities’ Views

37. The authorities broadly agreed with staff’s recommendations that there is room for strengthening the AML/CFT supervision of financial sector. The authorities noted the reduction in ML/TF risks facing the Estonian financial sector, particularly from non-resident activity. The authorities stressed that the current staffing level is generally enough for EFSA’s robust supervision going forward and agreed on the benefits of developing targeted and thematic on-site inspections. Discussions about the optimal process for imposing fines on financial institutions are ongoing. They observed that some of the recommendations, such as on development of formalized procedures for addressing identified violations, are already part of the EFSA 2019–22 Strategy.

Staff Appraisal

38. The economy remains strong. Growth eased further in 2019, but is projected to remain solid on the back of strong private consumption. With a positive output gap, wages are growing, and unemployment is at historic lows, reflecting tight market conditions. House prices remain in line with fundamentals. Headline and core inflation are above the euro area averages. The external position remains substantially stronger than implied by medium-term fundamentals.

39. The medium-term outlook is for slower growth. Looking ahead, growth is expected to revert toward its long-term potential, which is limited by Estonia’s unfavorable demographics and still-low productivity growth. Risks arise mainly from escalating and unpredictable international trade barriers, a growth slowdown in the main trading partners, and tightening financial conditions in Nordic countries. Domestically, continued wage pressures could hurt competitiveness.

40. The policy mix needs to address imbalances, while supporting economic activity. With the economy currently operating above potential, the current expansionary fiscal policy should be unwound. Over the medium term an appreciation of the real effective exchange rate is needed to restore external balance. In that context, the substantial fiscal space should be used to reorient fiscal policy to a more growth-friendly path. With monetary policy likely to remain expansionary for Estonia, macroprudential policies should aim to help contain financial sector risks that could arise from the low interest rate environment.

41. The substantial fiscal space should be used to raise productivity-enhancing investments, speed up work ability reforms and ALMPs, and enhance social spending to prepare for long-term demographic challenges. More investment in R&D would bolster incentives for broadening the economy’s innovation base. On the tax side, further enhancements would be welcome to support labor supply, particularly among low-income households, and to further reduce inequality. Over the medium term, such a policy stance would also help address Estonia’s external imbalance.

42. Changes to the pension system should preserve its viability and sustainability. The current pension system is fiscally sustainable owing to its low replacement rate, but its social viability could be enhanced. Proposed changes to the voluntary pillar II system risk moving in the opposite direction, however, and could also complicate macroeconomic management and slow capital market development. Staff urges the authorities to adopt a cautious approach in the review of the pension system, and to support the development of technological infrastructure to address concerns with the current system, including its high overhead costs.

43. Implementation of structural reforms needs to be accelerated, including to address inequality. The 2018 tax reform has helped to reduce the labor tax wedge for low-income earners, but more needs to be done to raise incentives for labor participation. In this context, the substantial fiscal space could be used for measures to increase public investment and labor supply to lift long-term growth. Structural reforms and other policy efforts should focus on further expanding firms’ innovation capacity, upscaling public and private investment in R&D. Also, it is important to accelerate labor market reforms by spending more on training to bridge skills gaps, enhance support services, and boost rehabilitation measures. Improving economic opportunities for women by closing the gender pay gap and further supporting childcare arrangements would promote growth potential.

44. The authorities should continue to monitor closely macrofinancial developments and there is room to enhance cross-border supervision. Staff welcomes the introduction of an average risk weight of 15 percent for mortgage loans, to be applied to the two systemic banks. In line with credit and macroeconomic developments, the level of the countercyclical capital buffer is appropriate. However, staff urges continued monitoring of macrofinancial and housing developments and related risks, while standing ready to activate macroprudential tools should cyclical risks intensify. The authorities should also seek to enhance cross-border supervision in line with the conclusion of the recent simulation exercise.

45. Continued reform in the AML/CFT regime is warranted. The notable improvements in the AML/CFT regime indicate a strong will to deal with related risks. Efforts to conduct an in-depth review of bank risk profiles and conduct a new ML/FT national risk assessment are welcome. Going forward, increasing the number of on-site AML/CFT inspections, ensuring the timely and dissuasive fines and considering regional consolidation of supervision at the regional level would contribute to strengthening the AML/CFT regime.

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

Figure 1.
Figure 1.

Estonia: Real Sector Developments, 2009–19

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: Haver; and national authorities.1/ Balance equals percent of respondents reporting an increase minus the percent of respondents reporting a decrease.
Figure 2.
Figure 2.

Estonia: External Developments, 2004–18

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: Haver; Statistics Estonia; and IMF staff calculations.1/ Other is defined as the sum of financial derivatives, and other investments.
Figure 3.
Figure 3.

Estonia: External Competitiveness, 2008–19

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: DOTS; Haver; WEO; and EU Commission.
Figure 4.
Figure 4.

Estonia: Fiscal Developments and Structure, 2003–18

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: WEO; Eurostat; and OECD.
Figure 5.
Figure 5.

Estonia: Financial Sector Developments, 2008–19

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.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.
Figure 6.
Figure 6.

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

(In percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Source: IMF staff.1/ Public sector is defined as general government2/ 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 7.
Figure 7.

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

(In percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Annex I. Implementation Status of Fund Advice

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Annex II. Energy Sector Developments

1. The energy sector plays a central role in Estonian economy. The energy sector represents a sizeable part of GDP and provides a significant job opportunity especially in the Ida-Virumaa county where the largest oil shale deposit is located. However, given its carbon-intensity, the recent increase in CO2 prices had a detrimental effect on the sector’s level of activity. The largest player in the energy sector, and the largest employer in the economy, Eesti Energia, a state-owned company, has laid off over 300 employees and has posted a net loss in this year third quarter.

2. Estonia is one of the most energy-intensive economy in Europe and the energy sector accounts for a large portion of CO2 emission. Estonian economy’s energy intensity has been declining since 2007, but it remains elevated, and is almost twice as large as the EU28 average. Thanks to its large oil shale reserves, Estonia covers around 70 percent of its energy consumption. Oil shale-based electricity production is highly carbon-intensive, but since the transition to market economy, greenhouse emissions have fallen in Estonia. However, the energy sector still accounts for 88.7 percent of these emissions in 2017.1

uA01fig01

Energy Intensity

(In Kilogram of oil equivalent per thousand Euro)

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: Eurostat

3. The government is planning to diversify electricity supply by investing in renewables and cleaner oil shale technology. Under the European directive above 25 percent target by 2020, Estonia has increased significantly the renewable energy share in its gross final energy consumption.2 Given the importance of the energy sector, the European Union 2020 strategy for building a competitive low carbon Europe by 2050 would have sizable implications for Estonia. To sustain the progress made in renewable energy production (wind farming, biomass and solar power plant), R&D investment in the energy sector would play a crucial role in facilitating the transition by improving the technology in power generation, energy storage (hydrogen) and transportation of electricity.

Annex III. External Sector Assessments

Estonia’s external position in 2018 was substantially stronger than implied by medium-term fundamentals and desirable policies. Over the medium term, Estonia’s current account balance is expected to decline toward the norm.

1. Estonia’s external current account (CA) surplus was 1.7 percent of GDP in 2018. Strong domestic demand contributed to high import growth (8.3 percent (y/y)), outpacing the still-buoyant export growth (6.8 percent (y/y)) in 2018. Meanwhile, the surplus in services declined by 0.8 percent of GDP. In 2018, the nominal effective exchange rate appreciated by 1.9 percent, while the real effective exchange rate (REER) appreciated by 3.6 percent. The appreciation can be explained by the strengthening of the euro against the currencies of major trading partners, while Estonia’s relatively high inflation also contributed.

2. The CA surplus in 2018 was substantially stronger than implied by medium-term fundamentals and desirable policies. The EBA-lite CA methodology suggests that Estonia is expected to run a cyclically adjusted CA deficit of 2.6 percent of GDP, consistent with its income convergence to the EU average and declining and ageing population. This leads to a CA gap of 4.3 percent of GDP (Text table), which implies a real effective exchange rate (REER) undervaluation of about 8 percent. The estimated policy gap is 2.2 percent of GDP, mainly explained by the need to achieve structural balance while increasing public health spending to address the rising public spending needs from ageing. The residual could be explained largely by rising private saving associated with ageing and one-off factors, including the temporary increase in EU funds disbursement and natural disasters and conflicts. Underpinned by strong domestic demand and moderating external demand, Estonia’s CA surplus is projected to gradually decline towards the estimated norm in the medium term.

Table. Summary of External Sector Assessment

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3. In line with the previous article IV assessment, the EBA-lite REER method finds a different result. It still suggests an overvaluation that leads to a narrowing REER gap of only 3.8 percent (Text table), compared to the 2018AIV, but contrasts an undervaluation of 8 percent implied by the CA model. This outturn is aligned with recent data on unit labor cost and productivity measures that indicate that Estonia is lagging the EU average (Figure 3). However, on balance, this does not suggest a need for exchange rate adjustment. Going forward, structural reforms that improve these indicators would help safeguard Estonia’s external competitiveness and help boost investment to further support the CA rebalancing.

4. Estonia’s net international investment position (NIIP) continued to improve, but remains negative at -26.3 percent of GDP in 2018. The NIIP increased by about 7 percent of GDP from 2017. The current account surplus contributed to this increase, which corresponds to a reduction in external vulnerability. The negative position largely reflects net inflow of FDI. Meanwhile, gross external debt has declined from 82.6 percent of GDP in 2017 to 76.2 percent of GDP in 2018, while net external debt remains negative at about -16 percent of GDP. Government fiscal reserves remain large (8.1 percent of GDP) and exceed gross government debt of 8.3 percent of GDP. While Estonia’s NIIP compares favorably with CEE peers, further improvement can enhance its resilience against shocks given ageing-related pressures and the volatility of portfolio flows.

Annex IV. External Debt Sustainability Assessment

1. Estonia’s external debt declined markedly in 2018 to 76.2 percent of GDP, from 82.1 percent of GDP in 2017, reflecting a decline in foreign deposits. Foreign deposits have declined by 3.2 percent of GDP in 2018.

2. Under the baseline, gross external debt is projected remain to below its historical average over the medium term. External debt is projected to stabilize at 73.4 percent of GDP in 2024. The current account deficit excluding interest payments is projected to improve and reach 0.4 percent of GDP by 2024, well above the debt-stabilizing non-interest current account balance of 5.6 percent of GDP. Gross external financing needs are projected to decline to 19.7 percent of GDP in 2024 from 27.2 percent of GDP in 2018.

3. External debt appears to be resilient to various shocks. Under all shocks and the historical scenario, including the combined shock scenario Estonia’s external debt-to-GDP ratio would be below its historical average of the last five years of 86.6 percent of GDP.

Table 1.

Estonia: External Debt Sustainability Framework, 2014–24

(In percent of GDP, unless otherwise indicated)

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Derived as [r – g – r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Table 2.

Estonia: External Debt Sustainability: Bound Test1,2

(In percent of GDP)

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Sources: International Monetary Fund, Country desk data, and staff estimates.

Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.

3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance. 4/ One-time real depreciation of 30 percent occurs in 2010.

Annex V. Making the Most of Public Investment Management

1. Estonia’s public investment management (PIM) is stronger relative to its EU peers. It ranks high on access to public infrastructure such as health, electricity, roads and water among 148 countries. PIM institutions generally perform well, and strong investment implementation is underpinned by: a robust legal framework for PIM; strong medium-term budgeting orientation; advanced e-procurement system; effective Treasury Single Account; and active project management by line ministries. Perceptions of Estonia’s infrastructure quality have already converged towards the EU average although it lags advanced peers.

2. There is scope however to strengthen planning, allocation and implementation of investments, in line with IMF FAD TA recommendations.1 Long-term strategic plans do not identify major investment projects in line with available fiscal space. Nationally funded projects are not appraised through a similar methodology applied to EU funded projects. Fiscal risks stemming from SOEs, local governments and PPPs are currently not systemically identified, monitored, nor reported, potentially undermining debt sustainability assessments. There is no formal protection of on-going projects. Lack of a consolidated project pipeline across sectors, comprehensive selection criteria, and centralized oversight of projects weakens implementation. Against this backdrop, the PIMA made recommendations including to:

  • Strengthen the realism of long-term strategic plans by identifying key investment projects, with indicative costing and reconciliation aligned with available fiscal space.

  • Establish 10-year public investment plans to consolidate medium-term capital planning and safeguard consistent treatment of all investment projects.

  • Develop a framework for monitoring and reporting of key fiscal risks, including for SOEs, and PPPs to strengthen the monitoring and accounting of contingent liabilities.

  • Adopt a standard methodology for project appraisal to ensure that all projects are appraised to a similar standard and subject appraisal documents to independent external review as a quality control measure.

  • Reinforce capital budget’s planning, appropriation and implementation by introducing additional disclosures on investment projects in the budget process.

  • Set up a unified pipeline of appraised projects for ease of comparison within and across sectors to foster transparency and competition.

  • Establish a centralized portal for project oversight to enhance monitoring and to minimize risks including cost and time overruns.

Annex VI. The Macroeconomic Implications of Changing Demographics

Over the next few decades, Estonia will experience significant demographic shifts. The analysis suggest that the expected population rebalancing will reduce labor supply, undermine productivity, and lead to a surge in age-related spending.

1. Population growth has trended downwards since the mid-1990s in Estonia. After the restoration of independence in 1991, the country has lost about 15 percent of its population. The declining path is largely driven by migration and low fertility rates, with over 60 percent explained by net migration. The contribution of net outward migration is expected to be outpaced by natural changes in the population. Total population is expected to decline by 5 percent by 2030 and 13 percent by 2050.

Figure 1.
Figure 1.

Population Trends for Estonia

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: UN WPP; UN World Population Projections; and IMF staff calculations.

2. Speed of ageing has progressed apace. The dependency ratio-defined as the ratio of people 65 and older to people between 15 and 64 has risen from 19 percent in 1980 to 29 percent in 2015. This reflects a growing number of older people spending more years in retirement relative to the working-age population. Old-age dependency ratio is projected to reach 52 percent by 2050 under unchanged policies.

Figure 2.
Figure 2.

Estonia: Population Distribution by Age Groups

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: United Nations, World Population Prospects and IMF Staff Calculations

3. The unfavorable demographic changes raise several challenges. The falling population is expected to result into a shrinking and ageing labor force. The labor force constituted 66 percent of the total population in 1980, but is now projected at 56 percent in 2050. The share of old-age workers, defined as workers aged 55 years or older, is expected to increase to 14 percent in 2050 from 9 percent in 1980. Over the same horizon, the share of prime-age workers (45–54 years) is expected to decline from 13 percent in 1980 to 10 percent in 2050. The share of the youngest cohort (15–24) is expected to decrease from 15 percent in 1980 to 10 percent in 2050, owing to the population bulge passing through to the older cohorts.

4. Changing demographics will have significant macroeconomic implications.1 The shrinking population will constrain labor supply, an important determinant of potential growth. A rising dependency ratio implies a reduction in the output per capita which would likely put pressure on public finances and likely affect incentives to save and invest. A recent IMF analysis2 suggests that between now and 2050, absent policy changes and reforms, outlays for pension and health care could increase to around 7 and 6 percentage points of GDP in advanced and emerging G20 countries, respectively. For Estonia, spending on healthcare and social protection is currently low.3Health expenditure is about ¾ of a percentage point of GDP lower than the EU average, but on par with the CESEE average. In PPP-adjusted terms, Estonia spent about USD 1,670 while the EU average was about USD3,100 in 2014. Expenditure is also particularly lower that the EU average for social protection by about 3.9 percentage points of GDP. Financing such increases in spending could lead to increased debt levels, or would require sharp cuts in spending, or necessitate large tax increases, unless revenue performance increases substantially.

uA01fig02

Labor Force Projections Under Baseline Scenario

(Percent change, 2015=100)

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: UN population projections and IMF staff calculations.

5. In the particular case of Estonia, we examined the implications of declining working age population for labor supply, based on different scenarios. Under a baseline scenario, the total labor force for each country is estimated by projecting the population of 5-year age cohorts and participation rates for each cohort, per the labor force decomposition.

L a b o r   f o r c e = ∑ j P o p u l a t i o n j * P a r t i c i p a t i o n   r a t e j ,

where j is a 5-year cohort of men or women from 16 to 80 years old. We use the United Nations population projections (2017 vintage, medium fertility scenario) for population projections. For future participation rates, current labor force participation rates for each cohort (from ILO data) are used. In cases where there are planned increases in statutory retirement ages, the participation rates of the older cohorts (those aged 55 to 70 years) are increased to match the rates in countries that have similar statutory retirement ages. Under current polices, the labor force in Estonia is still projected to decline by 11 percent by 2030 and 25 percent by 2050. The projection already factored into account legislated changes in the retirement ages.

6. We also investigate the potential for policies to offset the expected labor force decline. We employ three policy scenarios that are calibrated by changing participation rates for older workers and women, with same population projections as in the baseline scenario. The three scenarios include: (i) increasing the female labor force participation to the highest EU levels of the corresponding age cohort (for 25–45 years old); (ii) increasing the participation rates for older men and women (55 years and older) to the maximum achieved in EU countries; and (iii) raising the statutory retirement package to changes in life expectancy until reaching a ceiling of 67 years. To consider the reforms:

  • A moderate scenario assumes an average annual FLFP rate of 0.5 percentage points, corresponding to the average annual increase in the EU15 countries over the period 1995–2016; and an increase in the statutory retirement age linked to changes in life expectancy, but not higher than 67 years for both men and women.

  • An ambitious scenario assumes an average increase of annual FLFP of 1.3 percentage points, equivalent to the highest average FLFP increase achieved in an EU country (Spain) over the period 1995–2016; and the statutory retirement age increases to 67 by 2030 for both men and women and links further increases in the retirement age to increases in country-and-gender specific life expectancy in subsequent years (2030–50).

Figure 3.
Figure 3.

Impact of Policies on Labor Force Participation

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Source: IMF staff calculations.

7. The contribution of policies to reduce the decline in labor force is broad based (See Figure 3). Measures to increase the participation of women in the labor force could increase the available labor force compared to the baseline. Boosting participation of older workers without lifting the retirement ages would have a larger impact that increases over time as the share of older cohorts grows. In the long run, raising the statutory retirement age would bring the most significant impact, which could reduce the median decline in the labor force by nearly 10 percentage points.

8. Reforms, however, could only reduce, but not reverse the decline in labor supply. Under a moderate scenario, Estonia would close only 4.7 percentage points of the 25.4 percent gap, facing a high labor force decline of above 20 percent. With ambitious reforms, Estonia would close 11.1 percentage points of the gap, 86 percent driven mainly by raising the retirement age.

Empirical Method

The standard Cobb-Douglas production function with constant returns to scale, can be expressed as:

y i t = ( K Y ) i t α 1 − α A i t h i t ( 1 )

where yit is output per worker, K is capital per worker, Y is output, Ait is Total Factor Productivity, hit is human capital per worker, and α is the share of capital in output. We assume that the age structure of the workforce may have an impact on productivity growth:

Δ ⁢ log ⁡ y i t = f ( Σ s β s w s i t ) ( 2 )

where wsit is the share of each age cohort s in the workforce, and βs is the contribution of this age cohort to productivity growth.

The workforce age structure could affect labor productivity through several channels. Labor productivity can be determined by a combination of several drivers (equation 1)—capital intensity, human capital, and TFP— that could act as transmission channels from workforce aging to labor productivity. In the analysis below, we examine the relative importance of each.

The empirical analysis of the impact of workforce aging on labor productivity growth and its main drivers follows Feyrer (2007), Aiyar et al. (2016), and Adler et al. (2017), with a regression specification taking the form

Δ ⁢ log ⁡ Y L i t = α i + γ t + Σ s β s w s i t + δ y a d r i t + φ o a d r i t + ϵ i t ,

where YLit denotes output per worker, αi is a country fixed effect, γt are time dummies for several periods (1990–95, 1998–99, and 2008–09), oadrit is the old-age dependency ratio, and yadrit is the young-age dependency ratio.

We further decompose labor productivity to understand the relative importance of the channels through which workforce aging operates, thus estimating four equations, one for each of labor productivity, (physical) capital, human capital, and TFP. Regressing each component of the production function on the workforce age composition measures will therefore gauge whether workforce aging affects worker productivity through factor accumulation or TFP.

9. Since demographic changes could lead to a decline in labor supply, we examine the potential implications on productivity and growth. Using a production function approach can inform channels through which demographics affect growth (see Box). The estimation uses a panel data set with 167 countries over 1990–2014. Population data are taken from the United Nations World Population Prospects (2017) database and are available from 1950 onwards. The workforce data are from ILOSTAT. The young and old-age dependency ratios are calculated as the share of the population aged 0 to 14 and 65+ to the active population aged 15 to 64, respectively. The output per worker, capital stock, human capital and TFP data, which end in 2014, are taken from the Penn World Table 9.0.

Figure 4.
Figure 4.

Regression Results

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

10. The results (Table 2) show that an ageing labor force can significantly slow TFP and growth. A 1 percentage point increase in the share of older workers (ages 55+) in the workforce is associated with a decrease in growth of output per worker of 0.7–0.8 percentage points. Lower TFP growth, which decreases by about 0.6 percentage points for every point increase in the older worker share, has the most effect. The results seem to suggest that human capital is not an important channel. However, workforce aging is associated with a statistically significant increase in the capital-output ratio, suggesting that there may be some capital intensification to compensate for an older and less productive workforce.

11. A simulation of projected changes in the composition of the work force confirms that ageing would lower productivity. The projections of the UN WPP medium fertility scenario are multiplied by the labor force participation rates from the baseline scenario for each country and size of the labor force for each five-year cohort. The TFP impact is calculated by multiplying the projected differences in the share of workers aged 55+ in the total workforce for each five-year period from 2015 to 2050 by 0.6 (the estimated effect of the changes on TFP growth). The calculation implies that workforce ageing could lead to a 0.1 percentage point decrease in TFP growth for Estonia on average over the period 2015–50.

uA01fig03

Impact of Workforce Aging on TFP Growth

(Percentage point impact; average, 2020–50)

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Sources: UN WPP; ILO; PWT 9.0; and IMF staff calculations.

12. The impact of demographic changes on pensions and health care expenditure is assessed using projections developed by Clements and others (2015). These projections are used to derive on benefit and coverage ratios for each country based on the expected evolution of age dependency ratios and labor force participations rates. Estimates of labor force participation rates and output per worker are assumed endogenous. Potential cumulative liabilities associated with age-related expenditure are calculated as the net present value of pensions and health care spending.

13. The expected population changes will impose fiscal costs especially for public health care and pensions. Since pensions are paid to retirees, total pens ion spending should rise with the expected rise in the old-age population, while revenues will decline as the working-age population shrinks. In addition, as per capita health spending tends to rise with age, aging requires higher public health spending as well. On current policies, fiscal costs related to pensions and health care are expected to increase by nearly 3.2 percentage points of GDP, on average, between 2015–50 for Estonia (see chart). Most of the increase relate to pension expenditure that is expected to increase by 4.1 percentage points. In contrast, the fiscal costs for health expenditure only increase by 2.3 percentage points during a comparable period.

uA01fig04

Projected Change in Age-related Spending: Mid-Fertility Scenario

(Percent of GDP, change from 2015 to 2050)

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Source: IMF staff calculations.

14. Absent supportive policies, the increased pension spending could lead to socially unsustainable outcomes. The evolution of replacement rates—defined as pension payments as a percentage of pre-retirement earnings—remains a concern. The rates are below the minimum level of 40 percent recommended by the International Labor Organization by 2050. Recently adopted reforms could not completely reverse the decline in replacement rates. On average, a pensioner would receive nearly 24 percent of his or her preretirement earnings.

uA01fig05

Pension Replacement Rate, 2015–2050

(In percent)

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Source: IMF staff calculations.

15. Efforts to improve replacement rates would substantially increase pension costs. Bringing replacement rates to the recommended minimum level of 40 percent would increase estimated fiscal costs of pensions by 4.8 percentage points, on average for Estonia, between 2015–50. This would raise age-related spending from an average of 5.9 percent of GDP to about 10.7 percent of GDP.

uA01fig06

Projected Age-Related Spending Increases

(Percent of GDP, change from 2015 to 2050)

Citation: IMF Staff Country Reports 2020, 012; 10.5089/9781513526881.002.A001

Source: IMF staff calculations.

Annex VII. The Impact of the 2018 Personal Income Tax Reform

1. There are noticeable efforts to shift the tax burden away from labor. In 2017, the tax wedge for low-income earners at 36.8 percent for an employee earning 50 percent of the average wage was higher than the EU average of 32.5 percent. Against this backdrop, the government undertook to reduce the tax wedge for low-income earners by raising the tax-free allowance to 500 euros per month in 2018. The tax-free allowance for people earning more than the average salary decreases gradually and reaches zero once a person’s salary exceeds 2,100 euros per month.

2. The PIT reform has lowered the tax wedge, but contributed marginally to reducing inequality. Preliminary estimates indicate that the tax wedge for low-income earners at 29.7 percent for an employee earning 50 percent of the average wage was lower by 2.1 percentage points compared to the EU average of 31.8 percent. But for the poorest households that earn about 33 percent of the average wage, the tax wedge at 28 percent remained higher than the EU average of 27.6 percent. In order to gauge the impact of the reforms on income inequality, an approach using the microsimulation of a tax-benefit model EUROMOD developed jointly by the University of Essex and the European commission was invoked. Overall, the tax reforms appears to have a limited effect on income inequality as measured by the Gini coefficient (see table). The rate of at poverty risk, which is more relevant for inequality also marginally declined while disposable income increased in nominal terms.

EUROMOD Results on the Impact of Tax Reforms

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Source: Estonia Authorities

3. The distributive impact of the reform was favorable, with some fiscal costs. About 63 percent of all earners paid less PIT while net earnings remained stagnant for about 23 percent of earners. Among the pensioners, PIT payments were lower for a majority 58 percent, but net earnings remained the same for 35 percent of the group. Yet the fiscal costs of the reforms were not negligible. Preliminary estimates indicate that government will spend a cumulative 1.5 percent of GDP during 2018–20, slightly lower compared to earlier projections of 1.6 percent of GDP. This development reflect less use of the free allowance in 2018, tapping on the possibility to use half of the allowance and settle in PIT the rest. Overall, the changes imply that the marginal tax rate for low and medium earnings decreased providing stronger incentives to work more hours; however, at high earnings work incentives weakened because gradual withdrawal of the tax allowance increased the effective marginal income tax rate.
1

National accounts series were revised in August 2019 following recommendations of the gross national income verification cycle to improve the methodology, shift the reference year to 2015 and expand the data coverage.

2

Including teachers, health, internal security, and cultural workers.

3

The insolvency regime is characterized by a longer time before starting another business, inability to initiate restructuring, lack of an early warning mechanism and special insolvency procedures for SMEs.

4

Selected issues paper on Assessing Competitiveness and Exposure to Shocks Integrating Global Value Chains.

5

During the last three years, public wage grew at about 10 percent on average and 11 percent in 2019H1, while nominal productivity grew only by 6.4 percent in 2016–18 and 8.6 percent in 2019H1, respectively.

6

The Eesti Pank and the IMF organized a workshop that took place on September 30, 2019 in Tallinn that drew various stakeholders including pension experts to discuss experiences from Poland, Hungary, Sweden, and Estonia.

7

Social protection comprises unemployment insurance benefits—function of previous earnings and financed from statutory unemployment insurance contributions—and unemployment allowance—a flat rate that is financed from the budget.

8

Non-Estonian citizens with professional qualifications in any area, paid by their registered employer, at least double the annual Estonian average gross salary for working in their field of specialization in Estonia.

9

World Bank Ease of Doing Business Report.

10

The new EU directive aims at harmonizing the framework for preventive restructurings and to ensure that all jurisdictions can discharge debt within a reasonable time.

11

The acceleration of inequality around the year 2013 and 2014 could be due to a slow-down in GDP and wage growth respectively. Real GDP growth was 1.3 percent in 2013 and wage growth has slowed down to 5.9 in 2014 (from 7 percent a year earlier).

12

Relative poverty is defined as the proportion of the population with a disposable income lower than 60 percent of the median disposable equivalized income. The median equivalized disposable income is the total income of a household that is available for spending or saving, divided by the number of household members weighted by age.

13

Women vulnerability could also be explained by their relatively high life expectancy relative to men (82.4 compared to 72.9 years for men) as the at-risk of poverty is particularly high for persons living alone in this age group.

14

See Selected Issue Papers on Dimensions of Inequality in Estonia.

15

The LTV refers to the sum of all loans or loan tranches secured by the borrower on a property at the reporting date relative to the current value of the property, while the DSTI is the annual total debt service relative to the borrower’s total annual disposable income at the moment of loan origination. Maturity at origination’ means the duration of the residential real estate loan contract expressed in years at the moment of loan origination.

16

The Council of Europe’s Committee of Experts on the Evaluation of Anti-Money Laundering Measures and the Financing of Terrorism.

1

Ministry of Environment (Greenhouse Gas Emissions in Estonia 1990–2017, National Inventory Report).

2

The share of renewable energy in gross final energy consumption has reached 29.2 percent in 2017 (source: Eurostat).

1

FAD mission visited Tallinn, Estonia during November 28–December 12, 2018, to undertake a Public Investment Management Assessment (PIMA).

1

Staff Discussion Paper on Demographic Headwinds in the CESEE Countries by the European Department.

2

Note prepared by IMF Staff for the G20 on the Macroeconomics of Aging and Policy Implications.

3

Selected Issues Paper on Public Expenditure Efficiency in Estonia.

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Cover IMF Staff Country Reports
Republic of Estonia: 2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Estonia
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2020: Issue 012
Publisher:
International Monetary Fund
ISBN:
9781513526881
ISSN:
1934-7685
Pages:
69
DOI:
https://doi.org/10.5089/9781513526881.002
Text Figure 1.

Growth and Inflation
Text Figure 2.

Wages and Employment
Text Figure 3.

Fiscal and Current Account Balances
Text Figure 4.

Price Competitiveness and Non-Resident Deposits
Text Figure 5.

Real Estate Developments
Text Figure 6.

Macroeconomic Impact of Demographic Changes
Text Figure 7.

Developments in the Second Pillar Pension System
Text Figure 8.

Unit Labor Costs and Population Trends
Text Figure 9.

Employment and the Work Ability Reforms
Text Figure 10.

Insolvency Regime and the Gender Pay Gap
Text Figure 11.

Macroprudential Developments
Figure 1.

Estonia: Real Sector Developments, 2009–19
Figure 2.

Estonia: External Developments, 2004–18
Figure 3.

Estonia: External Competitiveness, 2008–19
Figure 4.

Estonia: Fiscal Developments and Structure, 2003–18
Figure 5.

Estonia: Financial Sector Developments, 2008–19
Figure 6.

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

(In percent of GDP unless otherwise indicated)
Figure 7.

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

(In percent of GDP unless otherwise indicated)

Energy Intensity

(In Kilogram of oil equivalent per thousand Euro)
Figure 1.

Population Trends for Estonia
Figure 2.

Estonia: Population Distribution by Age Groups

Labor Force Projections Under Baseline Scenario

(Percent change, 2015=100)
Figure 3.

Impact of Policies on Labor Force Participation
Figure 4.

Regression Results

Impact of Workforce Aging on TFP Growth

(Percentage point impact; average, 2020–50)

Projected Change in Age-related Spending: Mid-Fertility Scenario

(Percent of GDP, change from 2015 to 2050)

Pension Replacement Rate, 2015–2050

(In percent)

Projected Age-Related Spending Increases

(Percent of GDP, change from 2015 to 2050)