Abstract
2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Estonia
Macroeconomic performance and outlook
Estonia has witnessed solid economic growth in recent years as the economy has operated above its potential. The GDP growth in 2019 was around 3.5 percent driven by investments and strong private consumption, fueled by rapid growth in wages, and low unemployment. The manufacturing, information technology, and business services sectors had the most impact to the GDP increase, while construction and the energy sector contributed negatively to growth. The economic growth of 4.2 percent in the third quarter was surprisingly good but was lifted by one-off factors related to the agricultural sector and changes in consumption taxes.
Going forward, the Estonian economy will witness a gentle deceleration as the weaker outlook for foreign markets weighs on the manufacturing sector and exports. These developments, coupled with the stabilization of employment and a more modest growth of incomes, will somewhat ease consumption growth going forward. As a result, growth in the economy is expected to pull down close to 2 percent in the years ahead, while inflation will continue to rise slowly at a rate of around 2 percent.
The labor market is tight as the unemployment rate has declined to a record low level of 3.9 percent, while the labor force participation rate remains one of the highest in the EU. The limited labor supply has been somewhat eased by immigration, which has exceeded emigration for the past four years now. There has especially been an increase in recent years in temporary migration from outside the EU, which has significantly eased labor shortage pressures in certain sectors. The first signs of cooling are apparent in the labor market, as the more recent rise in registered unemployment and increasingly pessimistic employment expectations in the manufacturing sector indicate that the unemployment rate is expected to rise. The tight labor market conditions have resulted in rapid wage growth averaging 7–8 percent annually in recent years. With the economic climate cooling, the authorities expect that wage growth will ease somewhat, while wage pressures will probably remain relatively high in the future.
The authorities agree that risks to the growth outlook are skewed to the downside. Estonia’s small and very open economy is particularly vulnerable to the external environment. Therefore, weaker economic prospects for its immediate trading partners, trade tensions, and Brexit concerns could significantly hamper Estonia´s economic activity through the exporting sector. Domestically, risks could stem from the overheating of economy as limited labor has imposed strong cost pressures on companies thereby posing a risk to Estonia´s competitiveness and productivity.
Fiscal policy
Estonia is committed to pursue a sound and sustainable fiscal policy, which has served the country well and provided macroeconomic stability. Fiscal policy is aimed to preserve neutral or countercyclical budgetary policy, while maintaining the low level of government debt. Estonia’s gross public debt is currently at around 9 percent of GDP and net debt is close to zero due to sizable liquid reserves. The Ministry of Finance expects that the general government’s 2019 nominal budgetary position was close to balance (-0.1 percent of GDP), while the structural position improved to -1.2 percent of GDP. The authorities concur with staff that with the economy operating above its potential, the current expansionary fiscal stance needs to be gradually unwound. The State Budget envisages that in 2020 the budget will be in nominal balance and the structural position further improves to -0.7 percent of GDP.
The Government´s fiscal policy aims to improve social cohesion and reduce inequality, while maintaining prudent public finances. To set the fiscal policy towards more growth-friendly direction and to simplify the fiscal rule, the government is considering considers amending the current rule by waiving the requirement to compensate for the cumulative deficit that has arisen, and to restore the annual structural balance requirement. To improve the social safety net and meet the Government´s goal of reducing relative poverty to 15 percent by 2023, pensions will continue to grow in 2020 supported by extraordinary increase, while further investments are made to health care, social security, and education. The 2018 income tax reform, which raised the non-taxable income threshold and made the system more progressive, considerably improved inclusiveness and inequality. Last year, additional onetime benefits were paid to pensioners living alone, while family allowances were raised. According to OECD estimates, the combined effect of these measures reduced the Gini index of disposable incomes by roughly one percentage point. However, the authorities agree with staff that there is further scope to address wealth inequality.
The authorities agree that fiscal policy should be geared towards raising potential growth over the medium to long term by implementing productivity-enhancing investments, while fiscal space should be used to ensure positive returns for the entire economy without causing labor market distortions. The Government plans to implement multi-decade investment projects to upgrade infrastructure. The construction of Rail Baltica, a rail transport infrastructure project to integrate Baltic economies in the European rail network, is already in progress, while large-scale PPP infrastructure projects are considered to further improve transport connectivity. The authorities concur with staff that higher investment expenditures should be supported by improved efficiency of public spending and are committed to strengthening public investment management and a partnership framework for public-private investment, in-line with the PIMA recommendations.
The Government also prioritizes the development of a competitive economic environment and is taking steps to reduce excessive administrative burdens. On this regard, the Government has approved the initial state reform action plan for 2019–2023 aimed toward increasing the effectiveness of state tasks, lowering the administrative burden, and decreasing expenditures in the government sector.
Structural Policies
Given the already high employment rates and demographic challenges in the economy, the authorities acknowledge that there is a growing need to implement structural policies geared toward accelerating productivity and reducing skill gaps.
Productivity
The authorities agree with staff that scaling up public and private investment in R&D would broaden the economy´s innovation base and significantly enhance productivity. The Government has set the long-term target of increasing the private sector’s R&D expenditure to 2 percent and the public sector’s R&D expenditure to 1 percent of GDP. Additional resources in the 2020 budget are devoted to R&D with the aim of boosting productivity, which will further raise the share of science funding to 0.74 percent of GDP. A formation of joint strategy for R&D, innovation and entrepreneurship is currently being developed to reach the set targets with emphasis on significantly increasing the share of private sector investments. As a new measure, there are plans to set up a support fund for research and development intensive start-ups. While R&D spending has risen over the years in absolute terms, the authorities share staff´s view that there is scope to step up R&D expenditure to raise productivity and support convergence to EU income levels.
Labor market reforms
The Work Ability Reform has overhauled the disability pension system and unlocked resources for lower paid sectors. To further ease the tight labor market, the authorities have loosened restrictions in certain branches of the economy on hiring foreign labor outside of EU. The rapid wage increase, which has been consistently above productivity growth in recent years, is a concern and the authorities agree that high quality labor market policies aimed toward reducing skill gaps is important going forward. To alleviate skill shortages, the authorities are implementing measures to improve adults’ access to formal education, expand opportunities of in-service training and retraining. Higher and vocational education and retraining programs are being amended to ensure that the education system meets the needs of the labor market.
While the female employment participation rate is one of the highest in the EU, the relatively high gender pay gap, albeit on the downward trend over the years, is a concern for the authorities. To reduce the high gender pay gap in the private sector, a comprehensive evaluation of enterprises work and pay systems is planned and will be made available to employers to support them both in fulfilling legal requirements and taking voluntary measures to promote gender equality in their organization. Additional activities are being implemented to improve economic opportunities for women by providing adequate and flexible childcare arrangements and to increase paternity leave.
Pension reforms
In 2018, Estonia adopted the first pillar pension reform changing the pension formula and linking the pensionable age with life expectancy starting from 2027. These measures will support labor supply and increase average pensions in the future, especially for low-income earners.
The Government has announced plans to implement changes to the second pillar of the pension system in 2020 with the aim of making the pension system more flexible. The proposal, yet to be approved by the Parliament, allows individuals to opt-out from the mandatory privately-managed second pillar and gives them an opportunity to withdraw the accumulated funds before the retirement age. The planned changes also provide option to receive the second pillar pension as a lump sum or as an annuity from the pension fund or an insurance company.
The Bank of Estonia fully agrees with staff that the planned changes to the pension system will endanger macroeconomic stability as temporary boost fueled by increased consumption due to withdrawal of assets from pension accounts would be followed by slower growth or even a recession. In the long run, there is considerable risk that the planned reform would lower retirement incomes and raise old-age poverty, which ultimately results in higher fiscal costs. Risks to financial stability could stem from sell-off of investment assets, as pension funds need to liquidate their investments, including less-liquid investments made in the domestic financial market.
Financial policy
Financial stability
The Estonian financial system continues to be sound with a well-capitalized, profitable, and liquid banking system. The bank’s loan portfolio has shown strong growth, mainly driven by households, while borrowing by companies has been moderate. However, the households’ ability to service their loans has remained good and their indebtedness has not increased as incomes have risen fast as well. Given the recent moderate rise in housing prices and the current state of the economy, imbalances in the housing market are not significant. The authorities monitor the developments in the housing market closely.
Risks to the financial sector are low and mainly external. The risks could result from weaker than expected global growth and volatile financial market conditions. The Estonian banking sector has strong interlinkages with the Swedish financial system, as subsidiaries of Swedish banks account for two thirds of the banking market in Estonia. While loan portfolios of the subsidiaries are funded almost entirely from domestic deposits, the funding risks of parent banks also affect the Estonian financial sector. Domestic risks stem mainly from the build-up of vulnerabilities related to strong growth in household borrowing and real estate development activity.
The Bank of Estonia has introduced various capital buffer requirements and requirements for issuing housing loans to reduce the risks to the financial sector. A systemic risk buffer requirement of 1 percent applies to all banks in Estonia, with additional capital buffers between 1–2 percent required for the four systemically important credit institutions. As a new macroprudential measure, an average risk weight floor of 15 percent for mortgage loans was introduced for banks that use the internal ratings method for calculating risk-weighted assets. While the level of systemic risk coming from the housing market is not currently high, the aim of the measure is to ensure the resilience of the banks to the risks associated with housing loans.
AML/CFT developments
The authorities are concerned that the Estonian banking sector has been used for money laundering and are strongly committed to further strengthening the AML/CFT regime. The authorities have recently closed two banks that have breached the requirements of AML/CFT laws. As a result, the share of deposits held by non-residents in the Estonian banking sector have fallen dramatically in the past three years thereby substantially reducing the risks to the banking system. The authorities have recently reviewed the functioning of the AML institutional set up and related proceedings to ensure its effectiveness and to strengthen its AML/CFT regime more generally. The Estonian FSA has notably increased the number of staff to counter illicit finance, issued extensive guidelines to supervised entities, and conducted an in-depth review of bank risk profiles.
As a top priority for the Government, the authorities are taking forceful steps in the fight against money laundering by improving prevention and enhancing domestic and international cooperation regarding AML/CFT policies. Further funds have been allocated to the FIU and Prosecutor’s Office in this year´s budget and a Center for Strategic Analysis was established under the FIU, which will significantly improve the scope of preventing money laundering. On the legislative front, the Government approved the draft legislation, which improves the state’s possibilities to combat money laundering and transposes the EU Anti-Money Laundering Directive (AMLD V) into Estonian law. The legislation will significantly increase the fines for money laundering offences, as well as to expand the circle of persons who must comply with the requirements of the Money Laundering Prevention Act. The Estonian AML/CFT regime is scheduled to undergo an assessment by MONEYVAL in 2021.
Nordic-Baltic cooperation
The Estonian banking sector is closely interconnected with the Nordic-Baltic countries, therefore close cooperation within the region is essential. In January 2019, the Nordic and Baltic financial stability authorities conducted a joint financial crisis management exercise to strengthen the financial crisis preparedness. Based on the test results, follow-up work is planned for the coming years with the aim to enhance communication and collaboration between the Nordic-Baltic authorities. In addition, the authorities agree on the need for broader regional cooperation to strengthen AML/CFT supervision. In August 2019, the Nordic and Baltic financial supervisors agreed to establish a permanent working group to exchange experiences and information with the goal of being more effective in the prevention of money laundering.