Republic of Estonia: 2021 Article IV Consultation—Press Release; and Staff Report
Author: International Monetary Fund. European Dept.
Publication Date:
21 Jul 2021
eISBN:
9781513587370
Language:
English
Keywords:
debt ratio; fiscal policy; support measure; core inflation; wage support scheme
Download PDF (3.3 MB)

1. Estonia has been relatively successful in managing the initial impact of the COVID-19 pandemic. Until early-2021, the rate of infections was below that of most European countries, despite milder dejure restrictions on activity. Estonia relied on targeted restrictions and its improved medical system, including its relatively high ICU capacity.

Abstract

1. Estonia has been relatively successful in managing the initial impact of the COVID-19 pandemic. Until early-2021, the rate of infections was below that of most European countries, despite milder dejure restrictions on activity. Estonia relied on targeted restrictions and its improved medical system, including its relatively high ICU capacity.

Context

1. Estonia has been relatively successful in managing the initial impact of the COVID-19 pandemic. Until early-2021, the rate of infections was below that of most European countries, despite milder dejure restrictions on activity. Estonia relied on targeted restrictions and its improved medical system, including its relatively high ICU capacity.

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Number of ICU Beds Per 100,000 Population

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: National Center for Biotechnology Information
Text Chart 1.
Text Chart 1.

COVID-19 Cases and Deaths, February 2020-February 11, 2021

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

2. However, a much more vicious second wave of the pandemic has tested these achievements. A resurgence in infections since the fall of 2020 drove a return to significant economic restrictions. In early-2021, the rise in cases, which was fueled by new virus strains, was unexpectedly large and sustained. On March 11, 2021, the government introduced a strict quarantine, which lasted until April 25. Vaccinations have progressed in line with the euro-area average, with over 50 doses administered per 100 of the population by end-May, paving the way for a re-opening of the economy. The quarantine and progress with vaccinations led to a sharp decline in infections.

Text Chart 2.
Text Chart 2.

COVID-19: Second Wave and Vaccines

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

3. After promptly rebounding from a historic slump, the economy softened at the turn of 2020–21. As elsewhere, GDP imploded in 2020:Q2 due to hard restrictions and decreased mobility from surging health risks. An impressive bounce-back in H2 reflected the reversal of the restrictions, a snap-back in de-facto mobility, and policy support. However, in early-2021, rising infections led to renewed economic restrictions, though many activities have been adapting to the pandemic.

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Baltics average mobility in Retail and Recreation, Transportation, and Workspaces, 7-day average

(Percent deviation compared to value during Jan 3-Feb 6,2020)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Source: Google Mobility Database.

4. There was an unexpected change in government in early-2021, mid-way through the legislative term. Against the backdrop of a strong track record of institutional credibility, an alleged misappropriation of COVID-19 support funds contributed to the government resignation. The new government that took office in January 2021 was formed by a coalition of the Centre and Reform parties and has emphasized fiscal discipline, support to the elderly, and green and digital transition-related agenda among its priorities. Parliamentary elections are due in 2023.

The Economic Impact of the Covid-19 Pandemic and Policy Responses

Pre-COVID Landscape

5. Estonia entered the COVID-19 crisis in a strong overall macroeconomic position. Growth was robust, averaging 5 percent in 2017–19, with balanced contributions from consumption, investment, and net exports. Core inflation averaged around 2 percent and unemployment had been declining steadily, dipping below 5 percent in 2019.

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Text Chart 3.

Growth and Inflation

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

6. Public finances have for many years been sound, with very low public debt, limited fiscal deficits, and a solid asset position. The fiscal position is anchored by Estonia’s own structural balance rule. While in 2017–19 the fiscal stance accommodated significant spending increases and was moderately procyclical, fiscal deficits were contained. The gross public debt ratio (8.4 percent of GDP in 2019) has historically been the lowest in the EU, and net public debt has been negative until 2019.

7. Financial sector stability metrics were strong, though AML/CFT concerns lingered. The capital adequacy ratio, at 25½ percent in 2019, was among the highest in Europe, liquidity was ample, and the NPL ratio has been very low. Household and corporate balance sheets strengthened over the past decade, with lower leverage and an improved net asset position. The housing market saw sustained growth, but price momentum was aligned with income and other fundamentals. However, allegations of money laundering of non-resident deposits weighed on the financial sector.

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General Government Budgetary Performance

(Percent of GDP)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Estonia authorities; and IMF staff calculations.
Text Chart 4.
Text Chart 4.

Bank Prudential Ratio and Household Balance Sheets

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

8. The current account was consistently in surplus through 2019. This position was supported by strong services exports. The external performance was underpinned by wide-ranging reforms, including Estonia’s notable interrelated advances in private business facilitation and digitalization of government services.

9. However, several structural factors limit Estonia’s economic potential. Productivity growth has generally been below wage growth, dragged down by Estonia’s relatively small firm size, aging population, and low energy efficiency. Significantly, and unlike its Baltic neighbors, Estonia managed to mitigate population aging by reversing net out-migration since 2015. Despite good progress in reducing several social gaps over time, there remain long-standing challenges related to relative poverty, inequality, and gender pay disparities.

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Current Account Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Estonian authorities; and IMF staff calculation.
Text Chart 5.
Text Chart 5.

Productivity and Population Aging

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Real-Economy Crisis Fault Lines

10. The COVID-19 shock caused a decline of economic activity, stressing other aspects of the macroeconomy. For full-year 2020, output fell by around 3 percent and the output gap became negative. Inflation turned into deflation, reflecting the emergence of economic slack, weaker global energy prices, and excise tax cuts. The fiscal deficit widened to 4.8 percent of GDP and the public debt ratio jumped to 18.2 percent of GDP, although this reflects pre-financing from the 2020 EUR 1.5 billion Eurobond whose proceeds were not fully used by year end.

11. Economic developments in 2020 were highly uneven across sectors. Information and communications and financial services sectors were the relative “winners,” but hospitality, food, recreation, trade, and transportation services suffered. For these contact-intensive sectors, COVID-19 combined a deep demand contraction with negative productivity shocks as social distancing requirements increased unit production costs. Furthermore, these sectors are dominated by SMEs that have smaller buffers.

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Sectoral production over 2020Q1–2020Q4

(y/y growth, percent)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Statistical Office of Estonia, and IMF staff calculations

12. The economic contraction caused substantial aggregate employment losses and reallocation. Given Estonia’s relatively flexible labor market, unemployment increased perceptibly between March 2020 (5 percent) and December (to 7.5 percent). From a sectoral perspective, employment losses in the vulnerable food and hospitality, recreation, and real estate sectors were combined with perceptible wage cuts, which also affected domestic trade. However, overall wage growth in 2020 was positive, supported by the wage subsidy scheme and the fact that employment losses were concentrated among lower-wage earners (SIP on Labor Market scarring).

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Wages and Employment

(In percent)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Haver; IMF staff calculation.Notes: In the construction sector (excluded), employment increased by 39 percent y/y in 2020, while wages declined by 2 percent y/y in Dec 2020

Policy Response

13. Sizable measures were rapidly deployed to mitigate the effects of the pandemic. Measures centered on government actions and benefited from supranational support (Background Notes I and II). Coordination with EU institutions helped leverage the policy response. Estonia triggered national escape clauses from fiscal rules for 2020–21 in line with EU guidelines, permitting larger support to the recovery. The ECB provided substantial euro-area-wide policy support by easing financial conditions, including through large asset purchase programs.

14. Fiscal support was the cornerstone of the crisis response. Estonia promptly enacted a budget support package of 8½ percent of GDP. The execution of spending measures (a key countercyclical and health-sector-focused element) was comparatively high. The support covered many sectors, was implemented through multiple agencies, and scaled up nimbly when needed. The wage support scheme stood out due to its size and take-up in 2020.

Estonia’s 2020 COVID-19 Fiscal Response Package

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Sources: Estonian Authorities; and IMF staff calculations.
Text Chart 6.
Text Chart 6.

Estonia’s COVID-19 Fiscal Response

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

15. Financial sector support was provided mainly through bank moratoria. Most of Estonia’s banks participated in the moratoria that the European Banking Authority (EBA) initiated in March 2020, helping relieve pressure on firms and households. The moratoria were implemented flexibly, taking account of clients’ conditions. The coverage of loans peaked at around 10 percent and was concentrated among corporates. As bank exposures to vulnerable sectors proved limited, the coverage of moratoria became negligible by late-2020. Estonia also moved to relax its existing macroprudential systemic risk buffer, reducing it from 1 to 0 percent, while the countercyclical buffer was already at zero.

Text Chart 7.
Text Chart 7.

Loans with Active Moratoria

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

16. Health sector support measures are anchored by a proactive vaccination strategy. Estonia preordered sufficient vaccines from multiple suppliers to cover its population. The phased vaccination plan called for priority categories (e.g., the elderly and frontline workers) to be vaccinated first. The authorities target vaccinating 70 percent of the adult population by the fall of 2021.

Macroeconomic Impact of COVID-19

17. The policy response has greatly mitigated the COVID-19-induced economic decline. Estonia’s 2020 GDP contraction was appreciably smaller than in most of its EU peers, significantly reflecting policy support. Public sector consumption and investment were Estonia’s points of strength that supported demand. Large one-off transactions in 2020:Q4 complicate an assessment of significance of the unexpected strength in investment.

Text Chart 8.
Text Chart 8.

GDP Growth by Country and Demand Components

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

18. The support increased the 2020 budget deficit, but the impact of higher spending was partially offset by its impact on revenues. Total revenues declined by 1.4 percent y/y, as strong social contributions (7.1 percent) and PIT receipts (7.9 percent), which benefited from wage support measures, and EU grants helped offset weakness in CIT (-11.7 percent), excise tax (-20.5 percent), and nontax (-8.8 percent) revenues. Spending increases were heavily concentrated in transfers and subsidies.

Text Chart 9.
Text Chart 9.

Government Revenue and Expenditures

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

19. The financial sector absorbed the shock well. There was no indication of deteriorating bank solvency or liquidity (which benefited from higher precautionary savings). Estonia’s NPL ratios continued to decline through 2021 :Q1. As output stabilized and concerns about bank exposures waned, the initial decline in bank lending moderated in the fall of 2020. Lending interest rates have been broadly stable despite the ECB’s highly accommodative monetary policy. While the real estate market took a significant hit in 2020:Q2, it recovered quickly, and activity further accelerated in early-2021.

Text Chart 10.
Text Chart 10.

Lending and Real Estate Developments

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

20. Despite the swing of the headline current account into deficit, the external sector is still assessed as having been substantially stronger than justified by medium-term fundamentals and desirable policies in 2020. The deterioration of the current account reflects temporary factors, notably a large FDI-financed exceptional increase in computer services imports. Taking out cyclical and other temporary factors, Estonia’s real exchange rate remained substantially undervalued (as in previous consultations). The adjusted current account balance (5.8 percent of GDP) is estimated to be well above its estimated norm (-1.8 percent of GDP), implying a REER gap of 14½ percent in the preferred Current Account (CA) model (see Annex II). Nonetheless, the estimated decline in labor productivity (-0.8 percent) and rising unit labor costs (3.1 percent) in 2020 could chip away at the large undervaluation margin over time.

Estonia: Model Estimates for 2020 (in percent of GDP)

article image

Additional cyclical adjustment to account for the temporary impact of the oil trade balances (-0.05 percent of GDP) and tourism (0.34 percent of GDP).

Cyclically adjusted, including multilateral consistency adjustments.

Outlook and Risks

21. Output is expected to recover. Staff’s projections assume a robust recovery taking place in 2021:H2–22, driven by progress in vaccinations, ongoing policy support, a boost to domestic demand from the expected withdrawal of pension system savings starting from September 2021, and EU fund-backed public investment. Going forward, growth would gradually ease toward a potential of a little above 3 percent. Growth would be uneven across sectors with some permanent rebalancing of activity prompted by changed behavioral patterns and assumed macro-level scarring. Continued moderate bank credit growth will support activity. Other macroeconomic indicators will evolve in line with domestic and external developments:

  • Inflation is projected to increase but remain anchored. After upticks due to the rise in global commodity prices in 2021 and the expiration of the excise tax cuts in 2022, inflation will settle at around 2 percent over the medium term.

  • The external current account is expected to be moving toward small deficits under the influence of two countervailing forces. On the one hand, the reversal of the temporary deterioration in the services balance would push the current account toward a surplus in 2021. On the other hand, the expected inflows of EU funds and the broader economic recovery based on drawing down domestic savings will be import-intensive, pushing the current account towards a deficit (see Annex II).

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Real GDP

(In million euros)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Authorities; IMF staff calculation

Estonia: Summary Medium-Term Macroframework

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

22. Risks are balanced. With an unusually large two-way uncertainty, key downside risks include (i) an unexpected mutation of the virus derailing the global/regional recovery; (ii) the emergence of long-term economic scarring; and (iii) setbacks on cybersecurity or AML/CFT. On the upside, there are possibilities of (i) accelerated recovery in confidence due to successful vaccinations; and (ii) higher potential growth from digital and green technologies. The recovery in EU trading partners has a significant potential for regional spillovers, especially in the tourism and manufacturing sectors.

Authorities’ Views

23. The authorities broadly agreed with staff’s outlook and risk assessment. They thought that an economic recovery was well in sight but, at the time of the consultation, expected slightly slower economic momentum in 2021 compared to staff. At the same time, the authorities expect a faster growth acceleration in 2022 (to around 5 percent) due to the expected drawdown of the pension system and precautionary deposit balances that were accumulated during the pandemic. Despite the still negative output gap, they expressed some concern over risks of overheating in view of the expected sizable withdrawals from pension savings and possible spillovers to the housing market, though they deemed those risks manageable.

Risk Assessment Matrix1

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1 The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path. 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. The conjunctural shocks and scenario highlight risks that may materialize over a shorter horizon (between 12 to 18 months) given the current baseline. Structural risks are those that are likely to remain salient over a longer horizon.

Policy Discussions

Discussions focused on policies to: (i) support the recovery through a growth-friendly fiscal policy; (ii) address potential scarring while re-balancing the economy toward dynamic, inclusive, digital, and climate-friendly growth; and (iii) enhance AML/CFT frameworks while bolstering sound credit provision.

24. Substantial policy space offers unique scope for supporting the recovery and addressing medium-term structural challenges (Annex I). Despite the exceptionally low debt, there is a tension between (i) the need for an expansionary fiscal stance that favors recovery-related spending and transformational public investment, and (ii) Estonia’s traditional preference for a conservative fiscal stance. With supportive financial conditions, the suspension of the EU fiscal rules, and the significant grant component of NextGen EU being in train, the key effective constraint to the size of Estonia’s fiscal support to the economy will be the capacity of the government to spend effectively and efficiently. 1

A. Right-Sizing Fiscal Policy

Short-to-Medium Term: Supporting the Recovery

25. The 2021 budget appropriately tailors fiscal support to the pace of the expected recovery. The original 2021 budget which incorporated a carry-over of 2020 support measures, was augmented in April 2021 in response to the surging virus risks. The combined support package of 6½ percent of GDP includes:

  • Support to businesses. Provided through KredEx Foundation and Enterprise Estonia, it has targeted businesses that suffered large falls in income, including tourism and aviation sectors. As the economy recovers, staff expects the support —which had already declined—to be further scaled down.

  • Support to employees and households. The support includes unemployment benefits with skill-enhancing training programs and help with health sector contributions. It recorded the highest take-up, reflecting large support needs from COVID-19’s impact on households and the labor market.

  • Tax measures. The government extended the cut in excises on several fuels and instituted tax incentives, up to 2022, and deferred tax debt interest payments for 18 months.

  • Additional support. The new government has adopted a supplementary 2021 budget that enhances support by 2.2 percent of GDP, targeted to healthcare expenditure and support for employees and households.

Estonia’s 2021 COVID-19 Fiscal Response Package

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Sources: Estonian Authorities; and IMF staff calculations.

The 2021 suppl. Budget sets aside reserves to compensate for the temporary suspension of state contributions to the second pillar for those who applied to leave the second pillar by 31 March 2021.

26. The State Budget Strategy (SBS) of 2022–25 aims to tackle the pandemic and its medium-term impact. The SBS puts the priority on a prompt exit from the pandemic through pro-active vaccinations. Other main SBS policy priorities include (i) improving the accessibility and resilience of the health system; (ii) strengthening the social safety net; and (iii) ensuring dynamic digital and green transition through quality public investment and enhanced education and training. The SBS also envisions a gradual fiscal consolidation that would support the return to a rule-based framework.

27. Staff’s projections for 2021 (fiscal deficit of 6.3 percent of GDP) incorporate the authorities’ support measures and imbed the need for additional support. Support for workers and households should continue until the economy is durably on a sustainable path. Staff’s forecasts accommodate additional spending on the social safety net, including wage support. Revenues are expected to be lower (0.2 percent of GDP) than in the 2021 amended budget, mostly reflecting slightly lower private sector wage and personal income revenues. Expenditures are forecasted to be higher by 0.1 percent of GDP, reflecting higher compensation of employees (0.1 percent of GDP) and transfers to households (0.1 percent of GDP), partly offset by lower subsidies and other current transfers (0.1 percent of GDP).

28. Over the medium term, the authorities should use their ample fiscal space to boost capital spending, support the recovery, and increase potential growth.

  • Current expenditures. They are projected to decline gradually, in terms of GDP, as: (i) COVID-19 related transfers as a share of GDP are forecasted to decrease starting in 2022, while the workability reform aimed at improving labor participation is strengthened; (ii) public wage bill in 2022–23 would grow by 5 percent annually in nominal terms, reflecting the average annual salary increases and the needs for building skills and capacity in the digital and green sectors; and (iii) social benefits ease as a share of GDP starting from 2022 but remain above pre-pandemic levels, allowing room for the planned support for the elderly and improved social safety net, which is assessed to be low (2018 Article IV consultation SIP on spending efficiency).

  • Investments. The authorities’ new medium-term fiscal framework envisages somewhat lower capital spending ambitions relative to previous plans, while staff projects investments to grow steadily and reach 8 percent of GDP in 2025–26, assuming Estonia’s absorptive capacity gradually increases. The productive investment is expected to boost potential growth through projects with large multipliers and digital and green components, supported by EU financing and domestic resources (Table 2). 2

Longer-Term: Fiscal Policy Re-balancing Toward Transformational Investment

29. The Next Generation EU Funds is an opportunity to tackle medium-term fiscal issues and boost potential growth. (Annex IV). The government has submitted the final Resilience and Recovery Plan (RRP) in early June 2021. The RRP envelope, estimated at EUR 982.5 million (about 3.4 percent of GDP), is allocated over 2021–2026 (0.5 percent of GDP annually). The RRP, 80 percent of which consists of capital expenditure, covers projects aimed at strengthening the resilience of the health sector and easing the digital and green transition. By contributing to boost potential growth, RRP resources will create additional fiscal space to address the long-term challenges of aging population, healthcare, inequality, and gender gaps.

30. In this context, improving the management of public spending and investment is critical. To realize the payoffs from these investments that are envisioned under Estonia’s SBS and the new RRF and their multiplier effects, managing investment efficiency and effectiveness will be key (Annex V). 3 Speeding up the implementation of the recommendations of the PIMA report on long-term strategic planning and project implementation would be helpful. 4 Efficient and timely use of available EU funds, including the 2014–20 Cohesion Funds, which would expire in two to three years, and the Just Transition Fund, would require continued improvements in institutional capacities, including in local governments.

31. Fiscal transparency should be further upgraded to increase the effectiveness, and quantify the cost, of policy support. A recent assessment of Estonia’s fiscal transparency indicates an advanced stage of practices, though with scope for improvement (Annex VI). Given increased stakes involved in large-scale support, more holistic management of fiscal risks is needed, including quantification of risks from guarantees and potential cost of environmental risks and of quasi-fiscal activities. An integrated Fiscal Risk Statement that discusses the full range of fiscal risks and their costs would guide fiscal decisions. While the fiscal transparency assessment confirms the strong public procurement and governance procedures, there could be room for further enhancements, drawing on the experience of the pandemic package support management.

32. A robust plan for gradually rebuilding fiscal buffers and managing debt is also needed. Recovering economic activity will lessen the rationale for continued fiscal policy support. The forthcoming review of the EU fiscal architecture will help guide policy withdrawal. Without prejudging the review’s conclusions, Estonia’s targets should strike a balance between credibly maintaining fiscal discipline and maximizing high-multiplier spending. Quality measures and continued upgrading of asset and liability management should underpin those targets.

Authorities’ Views

33. The authorities concurred with the need to support the economy while the pandemic lingers but underscored the case for a balanced approach. In their view, the incipient recovery would justify discontinuing the wage support scheme around mid-2021, but they noted that upcoming deficit-neutral EU fund inflows and withdrawals of the pension savings would continue to stimulate the economy. In addition, the fiscal reserves allocated in the 2021 budget—and Estonia’s flexible budget management practices—would backstop deployment of further support, should it be needed. They are closely monitoring the pandemic using a composite indicator of health and vaccine metrics, which would help integrated decision making on re-opening and continued support programs.

34. Over the medium term, the authorities target a more prudent fiscal position, while leaving room to improve the quality of investment. The authorities noted that their new medium-term fiscal framework for 2022–25 aims at a gradual reduction of the fiscal deficit by at least 0.5 percent of GDP per year, in line with the national fiscal rule. The framework envisions generating expenditure savings while expanding elements of the social safety net and productive investment. The ongoing elaboration of RRF will help re-ignite the twin green-digital transition, the REACT Fund will support the labor market and health system, and the Just Transition Fund will help restructure the oil-shale sector. The authorities concurred with recommendations of the recent fiscal transparency TA and the 2019 PIMA and are working on their implementation, as well as further upgrading debt management.

B. Minimizing Scarring and Re-Tooling Growth Engines

35. As the effects of the pandemic subside, resources should be reallocated to address COVID-19’s multifaceted and potentially lasting economic damage. Reflecting its ample fiscal buffers, labor market flexibility, and strong institutions, Estonia is well-placed to repair damage to its productive fabric. However, it is more susceptible to the risks of “social scarring”. The COVID-19 crisis could exacerbate social concerns, as they can adversely affect skill accumulation, net migration, and sectoral mismatches, amplifying Estonia’s productivity challenge (SIP on Labor Market scarring). Effective and holistic structural reforms should complement fiscal support to labor and the social safety net.

Mending Estonia’s Productive Fabric and Fostering Better Jobs

36. Sectoral support programs should be maintained until the recovery is entrenched. While the authorities have recently decided to phase out wage support, staff urged for its prompt redeployment should the recovery falter. Other forms of support, including loan guarantees, should be continued as needed. Program design and targeting will need to be refined over time. Comprehensive monitoring of all types of support based on a battery of economic indicators and big data should guide decisions on the costs and benefits of different programs and the pace of their withdrawal.

37. Labor market flexibility should be supplemented with ramped-up active labor market policies (ALMP). The fall in Estonia’s 2020 employment has been particularly concentrated among the low-skilled and the young. This puts a premium on enhanced education and training that would relieve the long-standing shortage of skilled labor and prevent the atrophy of skills. Implementation of plans to expand retraining is ongoing. Strengthening ALMP and enhancing the workability reform would require expanding the means provided to the Unemployment Insurance Fund.

Text Chart 11.
Text Chart 11.

Risk Labor Market Scarring

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Healing “Pre-Existing” Conditions and Preventing “Social Scarring”

38. Targeted and effective interventions are needed to further reduce inequality, focusing on those most affected by the pandemic. Estonia has made welcome progress in reducing general inequality, with its Gini coefficient moving close to the euro-area average in 2019. However, data on at-risk poverty suggest substantial pockets of relative inequality, particularly among the elderly. These concerns are reinforced by the disproportionate impact of COVID-19 on the youth, people with low education, and the elderly, who could be additionally impacted by the change in the second pillar system. Staff welcomes the recent increase in pension entitlements, given their relatively low levels. A review of the pension system that is planned to be completed by 2022 will help map out the pension system’s objectives. Improved access to health services and following through on plans to enact a long-term care program are also important.

Text Chart 12.
Text Chart 12.

Inequality and Poverty

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

39. Determined actions are critical to addressing Estonia’s still-high gender gap. Estonia’s pay gap has narrowed in recent years, but it remains among the highest in the EU. The government’s Gender Equality Program envisions enhanced gender gap monitoring and evaluation and public awareness through digital tools. Ongoing activities include nudging programs (e.g., to remove gender glass ceilings in the ICT sector) and further measures for a more equitable work-life balance, including an enhanced paternity leave program of mid-2020. Further steps could be made to bolster safe child-care and long-term care services. A proposal for a yet-more far-reaching Welfare Development Plan 2023–30 is being elaborated.

Text Chart 13.
Text Chart 13.

Gender Pay Gap

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

40. Entrenching positive net immigration could help address the nexus between population aging, low-productivity, and lack of skilled labor. The COVID-19 shock, combined with the tight immigration quota, has blunted Estonia’s recent progress in attracting immigrants. The government should continue to actively expand business and labor regulations that helped catalyze net immigration, including training and education programs for immigrants, the e-residency program, and improved business climate, lower restrictions for impacted businesses, and further reduction of constraints to migration.

Text Chart 14.
Text Chart 14.

Population Trends and Net Immigration

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Seizing the Opportunity to Re-Ignite Digital and Green Growth at Frontier

41. Estonia’s advances in digitalization should be proactively strengthened. The COVID-19 shock underscored Estonia’s advantages, but it also inspired digitalization catch-up by its peers. The 2030 digigov strategy aims to lock-in Estonia’s global leadership in digital public services by boosting data governance and open data, core IT services, and last mile connectivity. Stepped-up digitalization of private businesses should continue to be incentivized through grants, investment support, and digital skills training. Other reforms include: (i) digitalization to speed up legal processes; (ii) support for broadband infrastructure (5G corridors); and (iii) further strengthening cybersecurity. The digitalization agenda will be supported with financial resources of the NGEU (Annex IV).

42. Staff urges the authorities to accelerate climate mitigation and the restructuring of the oil-shale sector. Estonia’s climate policy is being re-energized and aligned with the European Green Deal, including the goal of climate neutrality by 2050. The likelihood of reaching the emissions reductions target of 70 percent between 1990 and 2030 has improved, as the ongoing rebalancing of electricity production away from oil-shale is expected to be sustained. Progress hinges on (i) credibly addressing social and labor aspects of the oil shale industry’s restructuring (including pathways to alternative “green jobs”), which is supported by the EU’s Just Transition Fund, and (ii) implementing Estonia’s extensive transport electrification and renewable energy agendas. A comprehensive and predictable carbon pricing strategy, covering also transportation sector and buildings, should help achieve the emissions targets. 5 The Climate Change Adaptation Development plan envisions a range of additional projects and activities, including climate friendly buildings and infrastructure, land use and planning, bioeconomy, and ecosystems’ support.

Authorities’ Views

43. The authorities emphasized their pro-active structural and social reform agendas. On the wage support scheme, the 2021 budget allocation allows for full-year implementation should this be needed. Some support measures will remain, though they will increasingly take the form of financing or contingent assistance while being targeted to vulnerable sectors. In particular, support to the hard-hit tourism sector would continue beyond 2021. The ongoing revamping of the training curricula will help job reallocation. They stressed that support to the health system and the elderly would continue to be important, with both the pension increase and the minimum tax-exempt income threshold for pensioners planned for 2023. They also emphasized their extensive reforms to further reduce the gender gap, while several new programs would continue to incentivize immigration and skilled labor.

44. The authorities stressed their efforts to re-energize digital and green growth. They were pleased that public R&D spending was increased in the 2021 budget to 1 percent of GDP and planned to maintain this level going forward. They expected to use the RRF projects to spur digitalization and green growth. The authorities stressed their increasingly ambitious climate mitigation objectives, to be achieved through a combination of price and nonprice measures in coordination with the EU regulations. In particular, they have recently committed to achieving carbon neutrality by 2050, with intermediate sub-targets of discontinuing electricity production from oil shale by 2035 and the use of oil shale for the energy industry by 2040.

C. Supporting Financial Stability and Productive Credit

45. The financial sector has been weathering the pandemic well, but there is scope for bank credit to more fully support Estonia’s productive transformation. Despite very solid capital and liquidity buffers, Estonian banks’ credit to corporates has been relatively weak compared to some other euro area countries. Enterprise surveys indicate that although the availability of credit is improving, Estonian SMEs remain somewhat finance constrained. Bank profitability remained resilient, though it declined in 2020 (Table 8).

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Bank loans to NFCs, Amount Outstanding (NSA; corresponding period in 2019=100)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Haver Analytics, Eurostat

46. With bank moratoria and forbearance measures now being largely withdrawn, targeted support to borrowers needs to be retained. The central bank’s stress tests confirm the strength of balance sheets and low bank exposures pandemic-hit sectors, showing that, even in an adverse scenario, NPLs would rise significantly less than during the global financial crisis. With the moratoria now largely discontinued, banks can more soundly re-assess their borrowers, recognize losses, and step up the provision of credit to more viable sectors. At the same time, targeted financial support tailored to clients’ conditions should be considered by policymakers as needed given the remaining uncertainties and uneven impact of the pandemic.

Text Chart 15.
Text Chart 15.

Corporate Exposure and Scenario Analysis of NPLs

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

47. Supervisors and macroprudential policies should however remain vigilant. The supervisory framework is strong and has served the banking system well, but continued actions are needed:

  • Provisioning. Using flexibility to support borrowers, targeted and temporary interventions could be considered in problematic cases, but classification and provisioning rules should continue to fully apply.

  • Reporting. Given the difficulties created by the pandemic for some elements of the supervisory process, banks need to continue to conduct portfolio reviews and risk assessments on a regular basis. While some banks are already enhancing their reporting, it should be carefully applied across the industry, and banks’ public disclosures should continue to be fully transparent.

  • Housing market and macroprudential policy. Although the housing market has weathered the crisis well, it is critical as a preventive policy tool that the standard macroprudential instruments (debt to income, loan-to-value, and loan maturity cap requirements and the 15 percent risk weight for mortgage loans), be maintained to help keep the housing prices aligned with fundamentals. The authorities should be ready to re-calibrate tools in light of the risks of housing market overheating that are posed by the pension system withdrawals. As the economy recovers, the systemic risk and countercyclical capital buffers (both currently at zero) could be re-assessed and macroprudential tools may need to be used more actively if significant divergences with the euro-area’s cyclical conditions emerge.

Text Chart 16.
Text Chart 16.

Corporate and Household Debt

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

48. Remaining bottlenecks to resolving insolvencies should be forcefully addressed. The COVID-19 context has increased the importance of the insolvency framework. In January 2021, the authorities enacted amendments to the bankruptcy act that introduce a bankruptcy ombudsman, streamline procedures for accepting and defending claims, and increase specialization of courts. Consultations are underway for legislative changes that align the domestic framework with EU guidelines.

49. The AML-CFT reform agenda should be further advanced. The authorities have continued to make legislative and institutional progress in this area. The AMLTFP act was amended to incorporate the provisions of the EU fifth AML directive and entered into force in July 2020. The authorities’ efforts to tighten licensing and practices of virtual currency service providers are ongoing. The forthcoming evaluation by Moneyval in 2022 is an opportunity to assess and showcase progress in the AML/CFT area, and the authorities should mobilize the AML/CFT regime in preparation for this evaluation. As per recommendations of the previous Article IV consultation, the authorities have introduced thematic and targeted inspections of financial institutions, which should be continued. The process of imposing fines for AML/CFT violations should be streamlined. The upcoming regional TA’s recommendations on AML/CFT should also inform the reform agenda.

Authorities’ Views

50. The authorities broadly shared staff’s assessment of the financial sector’s health and policies. They stressed that the weak credit growth to corporates is primarily driven by lower demand, while broader financial system’s fundamentals for supporting financial stability, growth, and innovation remain good. Despite the strength of the financial system, they saw the need to maintain supervisory vigilance, noting that Estonia’s high level of digitalization helped ensure an efficient transition to new supervisory practices during the pandemic. They agreed that the macroprudential stance is appropriate and committed to further advancing the AML/CFT and insolvency-related reforms.

Staff Appraisal

51. Estonia has been broadly successful in managing the COVID-19 pandemic. The initial and subsequent lockdowns and restrictions on activity helped mitigate negative health outcomes but triggered a decline in economic activity. However, the rapid, broad-based, and sizable policy responses helped contain the economic damage, and the fall in output has been among the mildest in the EU. Vaccination rollout is being expanded and restrictions are being eased, paving the way for an economic rebound. Estonia’s external sector is assessed as having been substantially stronger than justified by medium-term fundamentals and desirable policies in 2020.

52. Output is set to recover, but the outlook is subject to large two-way risks. A robust recovery is expected in the near term on the back of progress with vaccinations, continued policy support, a boost to domestic demand from the expected withdrawal of pension system savings, and EU fund-backed public investment. There are however large two-way risks, including from virus mutations and economic scarring on the downside, and on the upside from increased confidence due to successful vaccinations and enhanced opportunities for digital and green transition.

53. Fiscal support should continue to be provided until the recovery is firmly entrenched. Estonia has ample policy space, reflecting prudent macroeconomic management and low debt. The fiscal support has been sizable, broad-based, and well-coordinated. While the current fiscal stance is appropriate, as health conditions improve and the economy recovers, the support should be gradually withdrawn. While some support measures have already expired as the economy has shown signs of recovery, they need to be promptly re-deployed should any signs of weakness emerge. In parallel, a plan to return to the medium-term objective should be part of a well-sequenced strategy to rebuild policy buffers and rebalance support toward productive investment. Further improving fiscal transparency and project implementation and maximizing the impact of NGEU grant funding should complement the envisioned scaling up of public investment.

54. Structural policies should aim to protect and revitalize Estonia’s productive and social fabric. Comprehensive monitoring of policy support and evaluation of experience should guide decisions on the costs and benefits of continuing with labor market programs to minimize labor market scarring. In parallel, active labor market policies should be ramped up to enhance training, match workers to good jobs, reduce skill shortages, and incentivize hiring. To manage potential social scarring risks, policies should continue to reduce inequality and gender gaps and further protect the elderly. The recent and planned increases in pension entitlements are welcome, and so is the planned review of the pension system. Further facilitating immigration could help address population aging, low productivity, and scarcity of skilled labor.

55. Estonia should further accelerate its green and digital transition. NGEU funds open up opportunities for further progress in the greening and digitalization agenda, where Estonia should supplement its commendable progress in digital public services with improved efficiency in R&D spending to enhance digitalization of private businesses. Drawing on the government’s strong commitment to more ambitious climate targets, the authorities should continue their efforts to implement all aspects of their reform agenda. In particular, comprehensive and predictable carbon pricing could be considered to achieve the emissions targets. Further steps should be taken to accelerate the restructuring of the oil-shale sector while managing its social impact.

56. Financial supervisors and macroprudential policymakers should remain vigilant. Estonia’s strong financial sector has weathered the pandemic well and helped support the economy. Financial supervision policies are appropriate, but continued careful monitoring is warranted. Banks’ exposures to pandemic-hit sectors seem to be contained, and banks can now more soundly reassess their borrowers and fully use the potential for credit provision while continuing to provide targeted support to vulnerable segments of the economy. The macroprudential stance is appropriate, though there is a need for a continued reassessment of the policy tools in light of developments in the real estate market. Staff welcomes the authorities’ continued progress with legislative and institutional reforms of the AML-CFT framework, which should be further advanced.

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

Figure 1.
Figure 1.

Estonia: COVID-19 Developments, 2020–21

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Bloomberg Finance L.P.; Our World In Data; IMF, WEO; and IMF staff calculations.
Figure 2.
Figure 2.

Estonia: Real Sector Developments, 2010–20

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Haver; and national authorities.1/ Balance equals percent of respondents reporting an increase minus the percent of respondents reporting a decrease.
Figure 3.
Figure 3.

Estonia: External Developments, 2004–20

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: Haver; Statistics Estonia; and IMF staff calculations.1/ Other is defined as the sum of financial derivatives, and other investments.
Figure 4.
Figure 4.

Estonia: External Competitiveness, 2008–20

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: DOTS; Haver; WEO; and EU Commission.
Figure 5.
Figure 5.

Estonia: Fiscal Developments and Structure, 2004–20

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Sources: WEO; Eurostat; and OECD.
Figure 6.
Figure 6.

Estonia: Financial Sector Developments, 2008–20

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.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 7.
Figure 7.

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

(in percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

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

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

(in percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2021, 160; 10.5089/9781513587370.002.A001

Source: IMF staff Calculations.
Table 1.

Estonia: Selected Macroeconomic and Social Indicators, 2018–26

(units as indicated)

article image
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 the Stabilization Reserve Fund (SRF).

Includes trade credits.

Table 2.

Estonia: Summary of General Government Operations, 2018–26

(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, 2015–20

(In millions of euros)

article image
Source: Statistics Estonia.

Including commitments under the European Financial Stability Fund.

Table 4.

Estonia: Summary Balance of Payments, 2018–26

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.