Republic of Estonia: 2024 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of Estonia
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1. Estonia, along with the other Baltic countries, is facing significant headwinds. Russia’s war on Ukraine triggered supply side disruptions and a large rise in inflation. Inflation has now eased, but wages and other input costs have shifted up compared to the euro area average hurting competitiveness. The capacity to absorb a common shock, however, has varied across the region.

Context

1. Estonia, along with the other Baltic countries, is facing significant headwinds. Russia’s war on Ukraine triggered supply side disruptions and a large rise in inflation. Inflation has now eased, but wages and other input costs have shifted up compared to the euro area average hurting competitiveness. The capacity to absorb a common shock, however, has varied across the region.

2. Estonia is underperforming. The country is going through a protracted downturn. Problems are deeply rooted and, at least partly, reflect structural forces. A lingering decline in productivity growth, combined with the recent sharp real exchange rate appreciation, has eroded the country’s competitive edge, and has led to significant losses of export market shares, taking a toll on potential growth (see Boxes 1 and 2).

3. Estonia is confronted with challenging policy decisions. Emerging needs to strengthen defense and accelerate the energy transition add to long-standing aging-related pressures. Earlier changes in the pension system have made contributions to the second pillar voluntary, leading to large withdrawals, and resulting in potential fiscal pressures in the longer run. The need to improve the quality and coverage of healthcare services may add to these pressures. And additional spending is needed to lift productivity and foster structural transformation. These pressures have already resulted in a deterioration of Estonia’s fiscal position. A tension between retaining the competitive tax environment and moving towards broader provision of public services and a stronger social safety net may lead to further fiscal deterioration, if left unaddressed (see Box 3). The authorities have generally implemented policies in line with Fund’s advice (Annex VI).

Recent Developments

4. The economy is caught in a prolonged recession. After recovering swiftly from the pandemic, real GDP has contracted on a sequential basis for nine consecutive quarters and is now about 6 percent below its 2021 peak. Timber and metals, previously imported from Russia and Belarus, are now sourced from more expensive markets. Euro appreciation against the Swedish and Norwegian Krona has also made Estonian products less competitive. Weak foreign demand and loss of competitiveness have depressed exports, forcing firms to cut back on investment and, more recently, jobs. In turn, rising unemployment, combined with tighter financial conditions, has weighed on disposable income and private consumption despite increasing real wages.

uA001fig01

Real GDP

(Index; 2021Q4=0%)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Sources: World Economic Outlook, IMF; and IMF staff calculations.Note: 2024Q1 numbers are flash estimates.

5. The labor market has been resilient, but it has weakened lately. Companies hoarded labor until recently but fading prospects of an imminent recovery and increasing real wages have taken a gradual toll on employment. The unemployment rate stood at 7.8 percent in 2024Q1, up 2½ percentage points from a year earlier. While unemployment is rising in manufacturing and construction, sizable vacancies are reported in defense, healthcare and education, and skill shortages have constrained growth in the ICT sector. A large share of Ukrainian refugees has been integrated in the labor market.

Text Figure 1.
Text Figure 1.

Estonia: Labor Market Developments

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

6. Inflation has eased. Driven by lower energy prices, easing supply chain disruptions, and increasing economic slack, headline inflation declined steadily from a peak of about 25 percent yoy in August 2022 to below 4 percent in late 2023, before rebounding on a 2-percentage point VAT hike. Staff estimate the VAT hike to have added 1.4 percentage points to inflation, with the effect falling out of the base in 2025. While headline inflation fell to 3.1 percent in April, core inflation still stood at 5.2 percent on higher service inflation. Real wage growth has started moderating recently but remains well above productivity growth.

Export Share Losses in Estonia and the Baltics1

Estonia has lost ground to its competitors in certain export markets above and beyond what can be explained by the individual dynamics in those markets – a sign of competitiveness pressures. To some extent, losses of export market shares are a regional theme. But in Latvia and Lithuania export share losses are smaller than in Estonia, and competitiveness issues play a much less prominent role overall.

Estonia’s export market share has fallen sharply in recent quarters. After a phase of significant gains in merchandise exports as a share of global exports, Estonia’s competitive edge slowly started eroding after the GFC. Recent shocks have exacerbated this trend. The export market share has steadily declined for eight consecutive quarters, falling by 23 percent between 2021Q3 and 2023Q4.

uA001fig02

World Export Shares

(Percent)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Sources: Direction of Trade Statistics, IMF; and IMF staff calculations.

Large negative contributions to the decline came from the US, the Netherlands and Latvia. The negative contribution from the US is particularly noteworthy, as the country ranked only as the 10th largest destination of Estonia’s exports in 2023.2 In contrast Sweden—one of Estonia’s largest export destination absorbing 9 percent of its exports in 2023—ranks only fourth on this measure. The role of Russia—not a key export market—was also limited.

uA001fig03

Estonia: Export Share Decline, 2021Q3–2023Q4

(Percentage points)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Source: Direction of Trade Statistics, IMF; and IMF staff calculations.

While the proximate cause of the decline has been an adverse combination of external shocks, a protracted fall in the trade share may also signal an inability of Estonian exporters to keep up with competition in destination markets. Using constant share analysis decomposition, it is possible to identify changes in export shares related to the intensive margin, i.e., a shrinking share of Estonia’s exports in the destination markets, and hence a measure of country’s competitiveness, from those reflecting composition effects related to changes in the size of the destination markets.

uA001fig04

Baltics: Contribution to Export Share Decline, 2021Q3–2023Q4

(Percentage points)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Sources: Direction of Trade Statistics, IMF; and IMF staff calculations.

The decline in Estonia’s export share has been largely driven by the intensive margin. Estonia has mostly lost ground to its competitors in certain export markets above and beyond what could be explained by the individual dynamics in those markets. During the post-Covid period, Latvia and Lithuania also experienced losses of export (cont.) shares, but these were less pronounced than Estonia’s (by 6 percent and 7 percent, respectively, vs. 22 percent in Estonia) and competitiveness played a much less prominent role overall.

TFP-Based REER and Competitiveness in Estonia and the Baltics1

Like elsewhere in the Baltics, Kalman filter-based estimates of potential GDP growth in Estonia have declined since the GFC. However, in Estonia this adjustment has been primarily driven by a fall in trend TFP growth. Falling productivity growth, combined with an appreciated real exchange rate, has likely reduced Estonia’s ability to absorb recent shocks, taking a toll on external performance.

Estonia’s TFP growth has declined since the GFC. Before the GFC, Estonia experienced rapid GDP growth. This was a period of significant capital deepening and steady income convergence towards more advanced EU economies. TFP provided substantial contribution to potential GDP growth at this time. However, since 2009, the contribution of trend TFP has turned negative. This contrasts with other countries in the region where trend TFP continued to account for a large share of potential GDP growth.

Box 2. Figure 1.
Box 2. Figure 1.

Baltics: Contribution to Potential GDP Growth, 1995–20231

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Note: Growth rates calculated as difference in natural logarithms of the original series.1 Latvia: 2002Q2–2008; Lithuania – 1999–2008

Unfavorable TFP dynamics have likely reduced Estonia’s ability to absorb shocks. A long-run cointegrating relationship between TFP and REER is used to produce a TFP-based REER equilibrium. Negative (positive) deviations of actual REER from this equilibrium indicate a competitive advantage (disadvantage). The analysis indicates that between 1995 and 2008 rapid TFP growth offered Estonia a competitive edge (negative REER gaps). This phase coincided with significant gains in export market shares. However, post-GFC, Estonia’s advantage slowly started eroding (positive gaps). Confronted with the recent sharp adjustment in prices and TFP decline, the country had more limited ability to absorb the shock compared to other countries in the region.

Box 2. Figure 2.
Box 2. Figure 2.

REER and Structural TFP

(LHS – natural logs; RHS – in percent)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Source: Statistics Estonia; Eurostat; Haver Analytics; and IMF staff calculations.
1 This Box was prepared by Carlos de Resende and Sadhna Naik. For an extensive discussion, see Selected Issues Paper “TFP Growth, the Balassa-Samuelson Hypothesis and Competitiveness in the Baltics.”

7. The fiscal position has deteriorated. Despite better-than-expected personal and corporate income revenue (a reflection of the until recently resilient labor market and robust corporate profits) and capital spending under-execution (partly on slow absorption of EU funds), the general government budget recorded a deficit of 3.4 percent of GDP in 2023, up from 1 percent a year earlier. The outcome, driven by a broad-based increase in current expenditure and weaker VAT revenue during the second half of the year, entails a fiscal stimulus—measured as change in the cyclically-adjusted primary balance—of about 1 percent of GDP. Even though public debt is significantly higher than in pre-pandemic years, it remains low at just below 20 percent of GDP, with a low overall risk of sovereign stress (annex IV). Fiscal space is still substantial.

8. The budget rule was loosened. Given Estonia’s low government debt ratio, significantly below 60 percent of GDP, and low risks to long-term fiscal sustainability, the medium-term objective in the State Budget Act was re-set to a structural deficit of 1 percent of GDP from an earlier balanced budget objective. Moreover, convergence towards the medium-term objective was redefined to account for economic conditions, as opposed to the earlier requirement of a structural improvement of 0.5 percent of GDP under any circumstances (Table 1).

Text Table 1.

Matrix of Budget Requirements

article image
Source: Ministry of Finance

Benchmarking Estonia’s Public Finances1

Emerging spending needs on defense and the energy transition add to long-standing ageing-related pressures. The tension between retaining the competitive tax environment and moving towards broader provision of public services and a stronger social safety net may lead to further fiscal deterioration, if left unaddressed.

Estonia’s government spending is relatively low, although in line with regional peers. Over 2017–2023, the Estonian government spent on average less than 38 percent of GDP, 11 pp and 6.5 pp less than the Nordics and EA20 countries respectively, but broadly in line with the other Baltics (Box 3. Figure 1).

Box 3. Figure 1.
Box 3. Figure 1.

Government Expenditures, 2001–2023

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Sources: Government Finance Statistics, IMF; and IMF staff calculations.

But spending pressures are likely to intensify. Since 2011, government expenditure as share of GDP increased by 6 percentage points, largely driven by the wage bill and social benefits. In staffs baseline it is projected to go up by another 3 pp in 2024. By function, most of the increase has been in defense, health, and social protection. Except for defense, Estonia underspends the Nordics and EA20 (Box 3. Figure 2) in these areas, suggesting potential future upward pressure. And while Estonia outspends the Nordics and the EA20 on education and R&D, spending in these productivity-enhancing areas has been declining as share of GDP. Spending in environmental protection and interests will also increase, given climate commitments, and rising public debt.

Box 3. Figure 2.
Box 3. Figure 2.

Estonia’s Govt. Expenditure by Function: Difference with Nordics and EA-20, 2017–2022

(Percentage points of GDP)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Sources: Government Finance Statistics, IMF; and IMF staff calculations.

Along with spending consolidation, options for revenue mobilization appear available. Tax revenues as share of GDP are low in Estonia relative to peers. Given Estonia’s per capita income, government revenues as share of GDP would be expected to be about 3 pp higher. Scope for additional tax revenues could be explored for income (especially corporate income) and property taxes, which are particularly low in Estonia (Box 3. Figure 3). These are also less distortionary than taxes on consumption (e.g., VAT and excise duties) and labor (social contributions), which already yield similar or higher revenues as share of GDP than in the Nordics and EA20 peers.

Box 3. Figure 3.
Box 3. Figure 3.

Estonia: Revenues from Corporate Income and Property Taxes, 2001–2022

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

1 This Box was prepared by Carlos de Resende and Sadhna Naik. For an extensive discussion, see Selected Issues Paper “Benchmarking Estonia’s Public Finance-A Primer.”

9. Financial conditions have tightened. The pass-through of ECB’s tighter monetary policy has been high, reflecting the prevalence of flexible lending rates and a significant switch from demand to term deposits. New credit has decelerated and demand of loans for house purchases and, especially, business investment has fallen sharply, according to the bank lending survey. House price inflation has moderated. A resilient labor market until recently and low corporate leverage have cushioned the impact of higher interest rates on balance sheets so far. However, financial leverage is higher among real estate companies, whose loans accounted for 37 percent of banks’ corporate credit at end-September, with even higher concentration among Less Significant Institutions (LSI).

Text Figure 2.
Text Figure 2.

Estonia: Financial Conditions

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

1/ For implementing Partial Least Square, authors’ divide the sample into distinct time periods, each with its regression. The indices are then chained together. It’s essential to note that the absolute FCI levels may not be entirely comparable to the early 2000s, given variations in available financial indicators. The final index chain covers most of the 2015–2023 period. 2023Q4 and 2024Q1 are forecasts.

10. Capital is adequate though solvency ratios vary significantly across banks. As elsewhere, Estonian banks registered record profits in 2023, and, despite higher interest rates, NPL ratios remain low so far. The aggregate Common Equity Tier 1 ratio is well above regulatory requirements at 20.7 percent of risk-weighted assets at end-2023, but heterogeneity across banks is significant. The two subsidiaries of Swedish banks (44 percent of total bank assets) rely on Internal Ratings-Based models, which traditionally result in lower risk-weights and higher capital ratios1, even though in the last two years these ratios have declined. Buffers are lower for LSI, especially in some cases. Recent one-off dividend payouts will support fiscal revenue but are estimated to reduce the aggregate bank capital ratio by around 3 percentage points (see Box 4).

Estonian Banks’ Capitalization and Regulatory Implications1

While capital levels remain adequate, solvency ratios of Estonian banks have gradually declined in recent years and exhibit significant variation across institutions. Reliance on Internal Ratings-Based (IRB) models in some banks has historically resulted in lower risk weights and higher capital ratios. The combined effect of higher risk weights and a recent large one-off dividend payout would reduce banks’ capital headroom considerably.

The capital position of Estonian banks has declined steadily over time and differences across institutions are significant. The average Capital Adequacy Ratio for the banking system has fallen from over 40 percent in 2014 to 21.5 percent recently, on account of several factors, including growing bank leverage and the expansion of banks’ loan portfolios as well as reforms to corporate taxation, which have incentivized banks to prioritize dividend payouts over profit retention. Small banks exhibit, on average, lower capital ratios than large banks. Differences across institutions are significant, with CET1 ratios ranging from 28 percent to 10 percent (Box 4. Figure 1).

Box 4. Figure 1.
Box 4. Figure 1.

Estonia: Bank Capital Adequacy

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

The high capital adequacy ratios of some Estonian banks partly stem from their relatively low risk-weighted assets. This is largely due to reliance on Internal Ratings-Based (IRB) models for certain segments of their loan portfolios. A 15 percent floor on average risk weights for mortgage loans, introduced by Eesti Pank in 2019 is lower than those in some Nordic countries with equally dynamic property markets. It is also notably lower than 35 percent risk weight uniformly applied under the standardized approach.

Two counterfactual exercises illustrate how IRB methodologies may result in lower risk weights and higher capital ratios. The first exercise explores the effect of imposing a 35 percent floor on mortgage loans. The second exercise considers the impact of a higher risk weight on NFC loans. The calibrated risk weight is assumed to be in line with the average of the Estonian banking system, estimated at 85 percent. Adopting more conservative risk weights for these two lending categories lowers the overall capital adequacy ratio of the banking system by approximately 200bps, from 22 percent currently to 20 percent (Box 4. Figure 2). Recent large one-off dividend payouts are estimated to reduce the average bank capital ratio by a further 3 percentage points, although the dividend payout may have not taken place had the risk weights been higher and the capital ratios lower. The combined effect of the higher calibrated risk weights and the dividend payout would significantly reduce Estonian banks’ capital headroom.

Box 4. Figure 2.
Box 4. Figure 2.

Counterfactual CAR

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

1 This Box was prepared by Gianluigi Ferrucci and Sadhna Naik. For an extensive discussion, see Selected Issues Paper “Estonian Banks: Capitalization, Profitability and Regulatory Implications.”

11. The external position is weaker than medium-term fundamentals and desirable policies (Annex III). In 2023, despite declining energy prices and significant import compression, weak foreign demand and real exchange rate appreciation left the current account deficit at 2.1 percent of GDP. After adjusting for one-off secondary income credits (excluding central bank monetary income) of about 0.6 percent of GDP, the current account-to-GDP ratio remained close to the widest deficit in fifteen years.

Estonia: EBA-lite Model Results, 2023

article image

Based on the EBA-lite 3.0 methodology

temporary adjuster to remove me one-off effect of an large increase in secondary income in December 2023, estimated at 0.6 percent of GDP.

Cyclically adjusted, including multilateral consistency adjustments.

Outlook and Risks

12. Growth is poised to make a gradual comeback in 2024. The policy mix is expected to be broadly supportive. Following a sizable stimulus last year, fiscal policy is expected to remain neutral in 2024 with automatic stabilizers supporting a recovery in economic activity, while looser financial conditions should sustain a rebound in credit growth. After stagnating in early 2024, growth is projected to recover, led by a rebound in export markets. Domestic demand should also strengthen as improved business confidence and easing financial conditions encourage firms to revisit investment and, eventually, hiring plans. Better job prospects along with real wage growth should support real disposable income and consumption. The slow start in the year is set to hold back average 2024 GDP growth at -0.5 percent, but growth is projected to pick up from -1.6 percent yoy in H1 to +0.6 percent in H2, and to gain further momentum in 2025.

13. Disinflation is set to slow before resuming in 2025. Despite recent signs of wage moderation, earlier generous public sector agreements and minimum salary increases have already locked in sizable wage gains for the year. Near-term wage growth along with the recently enacted VAT hike are expected to keep average inflation at around 4 percent in 2024, twice the euro area’s inflation target. Disinflation is expected to resume in 2025.

Summary Medium-Term Macroframework

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

14. Recent shocks have left scars. The recovery will extend into 2025 as fiscal and monetary policies remain mildly supportive under the baseline. However, despite the cyclical upswing, permanently higher input costs combined with weak productivity growth are expected to weigh adversely on Estonia’s external performance and potential output, with potential growth estimated at just around 2 percent (from 2¾ previously) and structural unemployment rising over the medium-term. The projected path of deficit reduction is seen missing the medium-term structural deficit target of 1 percent of GDP by a wide margin. The public debt-to-GDP ratio is expected to rise considerably to 34 percent of GDP over the forecast horizon. Interest payments are set to absorb a growing share of spending.

uA001fig05

Real and Potential GDP

(LHS – Million Euros, RHS – Percent of potential GDP)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Sources: World Economic Outlook, IMF; and IMF staff calculations.

15. The baseline is uncertain, with risks still skewed to the downside (RAM, Annex II). On the domestic front, the prolonged cyclical downturn may intensify calls for permanently increasing public spending while aborting plans to raise revenue. In contrast, a sharper-than-anticipated downward adjustment in prices and costs would deepen the recession in the near-term but may limit scarring.

16. External downside risks are significant. Increasing fallout from Russia’s war on Ukraine or an escalation of the conflict may further disrupt trade in the region and lead to a new wave of refugees. Volatility in commodity prices and renewed supply disruptions may trigger an abrupt downturn in the European economy and especially in Estonia’s main trade partners, further derailing prospects of recovery. Cyberattacks on physical or digital infrastructures may cripple payment systems and cause broader financial instability.

Authorities’ Views

17. The authorities broadly agreed with staff’s outlook for growth but remained more optimistic on inflation. While projecting annual growth to turn positive only next year, they expect easing supply chain disruptions, lower inflation, and looser financial conditions to boost economic activity already during 2024. They see improvement in real income and a resilient labor market supporting a recovery in consumption. Despite recognizing some near-term wage pressures and the impact of the VAT hike, they are more positive on the outlook for inflation, on account of limited domestic price pressures and lower passthrough from wages to prices. The authorities concurred that significant uncertainty surrounds the prospects for the region, reflecting ongoing geopolitical tensions, but saw increasing signs of stabilization.

Policies—Focus on Regaining Competitiveness

18. A well-coordinated policy response is needed to restore productivity growth and competitiveness. The current downturn reflects not only cyclical, but also structural forces. Estonia has lost significant export market shares in the last two years, but problems predate recent developments. External performance started weakening soon after the GFC, with productivity growth failing to keep up with real exchange rate appreciation at times. These problems are not insurmountable but require a decisive policy response. After a neutral fiscal stance this year, staff advocate for a return to fiscal consolidation to retain policy space as the economy exits the recession along with targeted structural measures to regain competitiveness and financial policies to preserve bank capital buffers.

A. Fiscal Policy—Preparing for Consolidation

19. Staff support a broadly neutral fiscal policy for 2024. The 2024 budget aims to support spending in military and national defense, cyber security, education, and green transformation through additional revenue from a 2-percentage point VAT hike, a one-off bank dividend distribution, and various environmental charges, while some social benefits have been clawed back. Staff expect the budget deficit to reach 3.8 percent of GDP this year, but in the near-term they support a neutral fiscal stance, given the prolonged cyclical downturn and the negative output gap. The government recently signaled the intention of enacting a supplementary budget to contain the deficit within 3 percent of GDP, but details are still scant.

20. However, a tighter fiscal stance is needed over the medium-term to support competitiveness and preserve buffers. A car registration and road tax worth ½ percent of GDP, already delayed until 2025, is still awaiting adoption by parliament. In addition, revenue measures of about 1 percent of GDP per year during 2025–27 are needed to secure convergence towards the new rule’s medium-term objective of a structural deficit of 1 percent of GDP. Scarring effects imply lower potential growth than previously anticipated and a narrower output gap (and thus a structural deficit further away from target), requiring a more prudent fiscal stance. As the economy exits the recession and the output gap gradually narrows, more resolute measures should be ready to support fiscal consolidation and preserve the policy space needed to lift productivity and foster structural transformation. Fiscal expansion, for example in the form of abandoning plans to raise fiscal revenue, would further erode the buffers needed to counter future spending needs. It might also slow disinflation and delay the improvement of Estonia’s external performance.

uA001fig06

Debt Under Different Fiscal Scenarios 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Sources: Ministry of Finance; and IMF staff calculations.1/ Recommended + fiscal rule: Δ Cyclically-adjusted balance = + 0.5 pp/year; end point: cyclically-adjusted balance = -1Downside Risk: Δ Cyclically-adjusted balance =baseline – 0.5 pp in 2024–25;Δ Cyclically-adjusted balance = -0.5pp/year from 2026.

21. Revenue measures should be considered to achieve fiscal consolidation. Under staff’s baseline, the structural deficit is projected at 2.4 percent of GDP in 2024 and is seen deteriorating further in 2025. The staff-recommended fiscal path instead entails a structural improvement of about 0.5 percent of GDP per year over the forecast horizon. In particular, staff urge the authorities to:

  • promptly adopt the car registration and road tax, to both raise tax revenue and support the green transition;

  • identify revenue measures worth one percent of GDP already planned in the budget strategy; and

  • accelerate the implementation of updated land taxable values and lift the exemption on primary residence plots, while considering the introduction of an immovable property tax.

Text Table 2.

Potential Measures to Support Fiscal Consolidation

article image
Sources: Ministry of Finance, IMF staff calculations

The combined effect of a higher personal income tax rate and basic allowance for all taxpayers is set to lower revenue and reduce overall progressivity of the tax system from 2025. In this context, staff encourage the authorities to assess whether the structure of the tax system meets the intended degree of progressivity.

22. Consolidation efforts should be accompanied by measures on the spending side. The public sector wage bill expanded considerably in 2023 on the back of ad hoc agreements with specific workers’ categories. Going forward, it is critical to contain public sector wages while limiting the discretion of line ministries, local authorities, and independent government agencies to raise wages. Staff welcome the ongoing spending reviews of the ministries of finance, economic affairs, and social protection and encourage the authorities to introduce means testing for social benefits.

23. The scope for strengthening the fiscal framework should be explored. The changes in the national budget rule have made the fiscal framework less ambitious, while the low government debt ratio along with low risks to long-term fiscal sustainability reduces the sense of urgency for fiscal consolidation, needed to prepare for future spending pressures. The uncertainty in assessing the volatile output gap and the structural balance further complicate matters. Among the options that could be considered to anchor the fiscal path more effectively is the introduction of a spending rule. Strengthening the resources and technical capacity of the Fiscal Council would also be important, along with a review of its governance arrangements.

Authorities’ Views

24. The authorities shared the thrust of staff’s advice on fiscal policy. They stressed the importance of sound public finance. While noting that fiscal policy has played an important role in supporting the economy in response to recent shocks and in limiting the extent of the downturn, they recognized that a budget stimulus would be no longer needed as the economy returns to growth. The authorities recognized that, in the absence of corrective measures, the budget deficit-to-GDP ratio would rise sharply in the coming years and so would the debt ratio, significantly constraining the ability of the economy to respond to future shocks and providing support as needed. The authorities concurred with staff that any fiscal adjustment should involve both expenditure and revenue measures.

25. However, the authorities noted that significant fiscal consolidation in 2025 may prove challenging. On revenue, they reiterated their commitment to adopt the planned car registration and road tax but noted that enacting other revenue-enhancing measures would likely take more time, given the legal requirement to pass any tax legislation at least six months ahead of its entry into effect. They discussed plans to introduce a broad-based national security tax to finance the increase in defense spending, but its implementation would likely be deferred to 2026. On spending, they welcomed staff’s advice to contain public sector wages while limiting the discretion of line ministries and other government agencies to negotiate ad hoc agreements with specific workers’ categories. They stressed the ongoing efforts in advancing targeted spending reviews, but cautioned on the expected cost savings that may be generated.

26. The authorities showed interest in staff’s proposal to strengthen the national fiscal framework. They agreed with staff that the low government debt ratio may reduce the sense of urgency for fiscal consolidation, while also recognizing the challenges involved in estimating a volatile output gap. Supplementing the existing framework with a spending rule was seen as instrumental to limit excessive growth in public expenditure going forward, while ensuring the long-term sustainability of public finance. The case for a debt rule was also given consideration in discussions with staff.

B. Financial Policies—Monitoring Risks and Preserving Capital Buffers

27. While still contained, financial stability risks have increased, reflecting the prolonged recession and tighter financial conditions. Developments in commercial and residential real estate warrant close vigilance, given the higher level of leverage among companies operating in this sector and the high concentration of real estate loans in banks’ credit portfolios, including for LSI. In 2019, Eesti Pank introduced a 15 percent risk weight floor for mortgage loans. Staff recommend that the authorities review bank exposures and ensure that credit risk is properly reflected in risk weights across the banking system.

28. The current macroprudential stance is appropriate. Despite the recent lending slowdown, staff support the decision to leave the countercyclical capital buffer at 1.5 percent (Table 3), given rapid credit growth in previous years. Staff also concur with the recent reduction of the reference rate used in debt service-to-income calculations, which had become excessively stringent against the background of tighter monetary policy (see Annex I).2 Recent efforts to improve harmonization of regulatory practices for LSIs, including use of Supervisory Review and Evaluation Processes, are welcome. Building on that progress, scope for higher macro- and micro-prudential buffers should be considered.

Text Table 3.

Macroprudential Measures

article image
Source: Eesti Pank.

29. Initiatives aimed at targeting bank profits to secure public funds should be discouraged as they weaken capital buffers. Higher bank profits are largely cyclical. Banks have already experienced declining lending volumes and higher funding costs and, over time, will likely face weakening asset quality. Against this backdrop, windfall taxes on excess profits and initiatives encouraging higher taxable dividend payouts should be avoided as they divert potential sources of capital from banks, reducing their ability to provide credit effectively and absorb future shocks.

30. Building on recent progress, systems should be further enhanced to address Money Laundering/Terrorist Financing (ML/TF) risks. Staff welcome ongoing efforts to enhance the supervisory capacity of the Financial Supervision and Resolution Authority and the Financial Intelligence Unit. In response to a recent MONEYVAL assessment, which found Estonia’s Anti-Money Laundering / Combating the Financing of Terrorism (AML/CFT) systems in need of further improvement, continuous priority should be given to mitigating cross-border ML/TF risks from higher-risk countries with material financial flows, further enhancing ML/TF risk assessments, and improving risk-based supervision of banks and virtual asset service providers. The legislation on crypto assets should be finalized given elevated risks stemming from the fintech sector.

Authorities’ Views

31. The authorities assessed the Estonian financial sector to have remained healthy, and potential risks to be limited so far. They emphasized that firms and households have absorbed well the impact of higher interest rates, thanks to strong balance sheets and a resilient labor market, but cautioned that banks’ asset quality could deteriorate if unemployment were to rise further. The authorities concurred with staff that risks stemming from commercial and residential real estate warranted close vigilance. While agreeing on the importance of credit risk being properly reflected in risk weights across the banking system, they deemed the current 15 percent risk-weight floor on mortgage loans appropriate and expected that the adoption of finalized Basel III rules in the EU next year would help reduce model risk and limit unwarranted variability in capital requirements of banks using internal models.

32. The authorities agreed on the importance of preserving bank capital buffers. They noted that while bank capitalization remains strong, it has declined in recent years reflecting change in the tax regime which encourage profit distribution. The authorities shared staff’s concerns about additional dividend payouts, which are estimated to reduce capital headroom considerably. The authorities concurred with staff that maintaining adequate buffers is critical to allow banks to absorb future shocks and ensure effective provision of credit over time.

33. The authorities highlighted their progress in dealing with ML/TF risks. They stressed ongoing efforts to strengthen the supervisory capacity of the Financial Supervision and Resolution Authority and the Financial Intelligence Unit and improved collaboration among agencies. They cited several initiatives to address the MONEYVAL recommendations and progress in enhancing reporting obligations of virtual asset service providers. The authorities also noted increased cybersecurity capabilities.

C. Structural Policies—Supporting Productivity and Fostering Transformation

34. Measures to boost competitiveness and counter structural headwinds are a priority. Against the backdrop of a structural decline in productivity growth and falling export shares, staff call for greater emphasis on supply-side policies. This includes measures aimed at increasing the quantity and quality of corporate investment, improving the reallocation of labor and capital towards higher value-added products and services, enhancing the adoption of digital technologies in traditional sectors, and ensuring that real wage growth remains closely aligned with productivity growth.

35. Staff encourage the authorities to build further on their progress in supporting labor reallocation. Staff analysis on allocative efficiency shows that insufficient labor reallocation across sectors and firms may have contributed to lower productivity growth.3 Staff welcome ongoing efforts to address labor mismatches and support reallocation through active labor market policies. Building on this progress, the authorities are encouraged to improve targeting of these schemes to cover segments of the labor market not sufficiently addressed and design outreach strategies to raise awareness. Scope for lifting immigration quotas should be assessed, while ensuring that minimum sectoral salaries properly reflect skills and qualifications. Efforts to reduce gender inequality in higher education and the labor market should be further pursued.

36. R&D investment and adoption of digital technologies in traditional sectors could be enhanced. Targeted subsidies may encourage applied innovation across firms and support the quality of corporate investment. Estonia has high venture capital and startup intensity but lacks corporate scale. Grants and measures to improve access to finance, especially in high social return sectors like green technologies, may support scaling up of startups and young firms. Public investment in basic scientific research with broad economic applications may further support productivity and innovation. Public-private cooperation, including with universities, can create positive synergies at lower cost for public finances. Recalibrating current spending towards productivity-enhancing capital spending, including through timely and efficient absorption of EU funds, would also be important to restore competitiveness.

37. Estonia’s economic transformation could also be supported by a more ambitious green transition. At current policies, Estonia’s goal to achieve climate neutrality by 2050 is largely out of reach. Phasing out the domestic oil-shale sector, introducing a carbon tax, and extending the coverage of sectors where carbon pricing applies, currently the lowest in the EU, remain key to achieving EU climate objectives. Fossil fuel subsidies should also be revisited with a view to facilitate decarbonization. Staff welcome the recent progress in accelerating deployment of renewables and urge the authorities to boost energy efficiency in the building and road transport sectors.

Authorities’ Views

38. The authorities agreed with staff on the importance of boosting productivity and restoring competitiveness. They emphasized that the long-term prospects of the Estonian economy largely hinge on firms’ ability to remain competitive in export markets and attract productivity-enhancing investment. They acknowledged that inflation and supply chain disruptions have now receded, but input costs are significantly higher. They also recognized that while weak demand from key trading partners has depressed exports lately, a vanishing price advantage may have also contributed to Estonia’s loss of market shares.

39. The authorities highlighted the role of human capital in raising potential growth. While emphasizing their progress on reskilling and upskilling workers through active labor market policies, the authorities saw merits in staff’s recommendations to improve targeting and raise awareness around available schemes. They expressed interest in staff’s proposal to lift immigration quotas. The authorities also acknowledged the importance of increasing the share of STEM university graduates, including by addressing the existing gender bias, to mitigate the structural shortage of skilled labor in the ICT sector.

40. The authorities also concurred with the need of further raising Estonia’s stock of physical capital. To this end, they noted that EU funds can play an important role in catalyzing private investment, while recognizing the challenges encountered in absorbing and allocating these funds efficiently. The authorities also highlighted ongoing efforts in boosting Estonia’s longstanding digital advantage, increasing its attractiveness as an investment destination, and gathering venture capital to develop start-ups. They agreed on the importance of enhancing R&D investment and adoption of digital technologies in traditional sectors.

41. The authorities saw scope for a more ambitious green agenda. The authorities are committed to enhancing the energy mix by gradually reducing reliance on oil shale in electricity generation and boosting investment in renewables, especially wind farms, where regulatory and legal constraints are being eased. They intend to decrease current subsidies for fossil fuels, expand the coverage of sectors where carbon pricing applies, and enhance the energy efficiency of the transportation and construction industries.

Staff Appraisal

42. Estonia is going through a prolonged downturn, but problems predate recent developments. Russia’s war on Ukraine triggered supply side disruptions and a large rise in inflation in the Baltic region. Inflation has now eased, but input costs have shifted up compared to the euro area average. These developments compounded longer-standing problems for Estonia. A secular decline in productivity growth, combined with the recent real exchange rate appreciation, has eroded the country’s competitive edge, and has led to significant losses of export market shares. The external position is weaker than medium-term fundamentals and desirable policies.

43. Growth is poised to make a gradual comeback. Led by a rebound of foreign demand and a broadly supportive policy mix, growth is projected to recover after stagnating in early 2024. Domestic demand should strengthen as well as improved business confidence and easing financial conditions encourage firms to invest and, eventually, hire. Better job prospects along with real wage growth should support real disposable income and consumption. Inflation has slowed, but sizable wage gains along with the recently enacted VAT hike are sources of near-term upward pressure.

44. But recent shocks have left a mark. The recovery is expected to continue into 2025 as the policy mix remains mildly supportive under the baseline. Despite the cyclical upswing, however, permanently higher input costs combined with weak productivity growth are expected to leave a scar, weighing adversely on Estonia’s external performance and on potential output.

45. The baseline is uncertain, with risks still skewed to the downside. On the domestic front, the prolonged cyclical downturn may intensify calls for permanently increasing public spending while aborting plans to raise revenue. In contrast, a sharper-than-anticipated downward adjustment in prices and costs would deepen the recession in the near term but may limit scarring.

46. External downside risks are also significant. Increasing fallout from Russia’s war on Ukraine or an escalation of the conflict may further disrupt trade in the region and lead to a new wave of refugees. Volatility in commodity prices and renewed supply disruptions may trigger an abrupt downturn in the European economy and in Estonia’s main trade partners, further derailing prospects of recovery. Cyberattacks on physical or digital infrastructures may cripple payment systems and cause broader financial instability.

47. A well-coordinated policy response is needed to restore competitiveness. Problems are not insurmountable but require decisive policy actions. After a neutral fiscal stance this year, staff advocate for a return to fiscal consolidation to retain policy space as the economy exits the recession along with targeted structural measures to raise productivity and regain competitiveness and financial policies to preserve bank capital buffers.

48. Staff support a broadly neutral fiscal policy for 2024, but a tighter stance is needed over the medium-term. Given the persistent negative output gap and substantial fiscal space, a neutral fiscal stance for this year is appropriate. However, as the economy exits the recession, and the output gap gradually narrows, more resolute measures both on the revenue and the spending side should be ready to support fiscal consolidation and preserve the policy space needed to lift productivity and foster structural transformation. The introduction of a spending rule could be considered to anchor the fiscal path more effectively.

49. While still contained, financial stability risks have increased, reflecting the prolonged recession and tighter financial conditions. Developments in commercial and residential real estate warrant close vigilance, given the higher leverage among firms in this sector and the high concentration of real estate loans in banks’ credit portfolios, including for LSIs. Staff recommend that the authorities review bank exposures and ensure that credit risk is properly reflected in risk weights across the banking system.

50. Bank capital buffers should be preserved. The current macroprudential stance is appropriate. Recent efforts to improve harmonization of regulatory practices for LSIs are welcome. Windfall taxes on excess profits and initiatives encouraging higher taxable dividend payouts should be avoided as they divert potential sources of capital from banks, reducing their ability to provide credit effectively and absorb future shocks. Building on recent progress, systems should be further enhanced to address ML/TF risks.

51. Measures to lift productivity and regain competitiveness are a priority. Greater emphasis should be placed on increasing the quantity and quality of corporate investment, improving the reallocation of labor and capital towards higher value-added products and services, enhancing R&D investment and adoption of digital technologies in traditional sectors, while ensuring that real wage growth remains closely aligned with productivity growth. Estonia’s economic transformation would be supported by a more ambitious green transition.

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

Figure 1.
Figure 1.

Estonia: Growth Developments

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Figure 2.
Figure 2.

Estonia: Inflation Developments

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Figure 3.
Figure 3.

Estonia: General Government Fiscal Performance

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Figure 4.
Figure 4.

Estonia: Bank Credit Developments

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Figure 5.
Figure 5.

Estonia: Bank Capital Adequacy and Asset Quality

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Figure 6.
Figure 6.

Estonia: External Position

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Figure 7.
Figure 7.

Estonia: Climate Change Indicators

Citation: IMF Staff Country Reports 2024, 177; 10.5089/9798400278303.002.A001

Table 1.

Estonia: Selected Macroeconomic and Social Indicators, 2022–29

(Units as indicated)

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

Includes the Stabilization Reserve Fund (SRF).

Includes trade credits.

Table 2.

Estonia: Summary of General Government Operations, 2022–29

(Percent of GDP)

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

Estonia: General Government Financial Assets and Liabilities, 2016–23

(In millions of euros)

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Source: Statistics Estonia.

Including commitments under the European Financial Stability Fund.

Table 4.

Estonia: Summary Balance of Payments, 2022–29

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Sources: Eesti Pank; 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.

Table 5.

Estonia: Macroeconomic Framework, 2022–29

(Percent of GDP, unless otherwise indicated)

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

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.