12 March 2014

Concluding statement of IMF 2014 Article IV mission to Estonia

Estonia's recovery from the crisis continued in 2013 but at a slower pace. Estonia is now well advanced in the process of establishing a more complete and stronger macro-prudential toolkit.

1. Estonia’s recovery from the crisis continued in 2013 but at a slower pace. Preliminary data indicate that growth was 0.8 per cent in 2013, with a deceleration during the year. Private consumption provided the main support for growth, while net exports made a negative contribution. However, some of the slowdown is due to one-off factors, and we expect growth to pick up again in 2014 and 2015, broadly in line with the forecasts of the authorities and other outside observers.

2. Nevertheless, there are signs of overheating in the labour market and other indications of more rapid growth. (...)

3. The economy seems to be roughly at its potential level.The national accounts data are at odds with other data that suggest somewhat higher real growth and lower inflation than the GDP deflator. However, the conflicting signals between national accounts and other data create more than the usual amount of uncertainty as to where the economy is relative to the potential output level.

4. Indicators of competitiveness are generally good, but rising wages and prices are putting pressure on price competitiveness. The current account deficit is small and shrinking and exports and export market shares have been growing. However, demand remains weak in many of Estonia’s most important export markets, and real effective exchange rates are appreciating, whether calculated on the basis of price indices or unit labour costs.

5. Fiscal policy has remained conservative throughout the cycle. The deficit never exceeded 3 per cent of GDP during crisis, and the budget has been mostly in surplus since then. While this near-balanced budget policy has kept public debt low, it has also added a pro-cyclical bias to economic policy.

6. Estonia’s banks and their Nordic parents are well capitalised, liquid, and have low levels of non-performing loans. The banks have the capacity to increase lending, although credit growth is modest and has only recently turned positive. Both business surveys and balance sheet data indicate that corporations are being cautious in their investment plans, and they are generally able to finance investments from retained earnings. Households are repairing their balance sheets and are cautious about new borrowing. With the loan-to-deposit ratio now just close to one, the banking system appears to have reached a sustainable equilibrium.

Outlook and Risks

7. Growth should pick up in 2014 and the medium-term. We expect growth to rise to 2½ per cent in 2014 supported by both external and domestic demand and then rise toward expected potential growth of 3 to 3.5 per cent in the medium term. Inflation’s downward trend is expected to continue, but slowed by increased wage pressure. Projected inflation should trend down toward 2 per cent over the medium term. This is above the euro area average, but it is consistent with what would be expected for a country converging with its higher-income partners in the euro area.

8. Risks are tilted moderately toward the downside and mostly relate to trade. (...)

Fiscal policies

9. The 2014 budget continues the Estonian tradition of prudent fiscal policy. The projected headline deficit of 0.4 per cent of GDP would maintain the deficit at the same level as the 2013 outturn, while the structural balance improves to a surplus of 0.7 per cent. This budget should meet the requirements of the Fiscal Compact, and the projected structural surplus should provide a margin above Budget Law’s target that could accommodate negative fiscal surprises.

10. The structural surplus target embodied in the new Budget Law should help to address the previous pro-cyclical patterns on fiscal policy.  (...) The government’s medium-term plans to keep the structural surplus well above the medium-term objective for the Fiscal Compact will keep the government’s balance sheet strong and provide a margin to accommodate negative fiscal surprises or disagreements as to whether the target is met based on alternative estimates of the structural balance. The authorities are also in the process of setting up a Fiscal Council in line with the Fiscal Compact. These policies will further bolster Estonia’s resilience and credibility on fiscal policy.

Financial sector policies

11. Estonia is now well advanced in the process of establishing a more complete and stronger macroprudential toolkit. The draft amendments to the Eesti Pank Act and the Credit Institutions Act would establish the Eesti Pank as the macroprudential authority, give it the macroprudential tools specified in the CRD IV, and provide the authority to make macroprudential limits such as loan-to-value and debt-service-to-income ratios requirements rather than guidelines. The Estonian authorities are also implementing the new financial architecture of Basel III, with the capital conservation buffer, the systemic risk buffer, and the countercyclical capital buffer to be implemented shortly after pending legislation is enacted and the Liquidity Coverage Ratio to be implemented by January 1, 2015. The systemic risk buffer is expected to be set at 2 per cent while the countercyclical buffer is expected to be set at zero initially. Enactment of this legislation and its implementation as planned would complete most of the outstanding domestic agenda on the Basel III reforms and go a very long way toward ensuring financial sector stability.

12. The Estonian authorities should be proactive in implementing the Banking Union while preserving Nordic-Baltic institutional structures. The authorities will need to work with the ECB and any other relevant Banking Union entities on Banking Union implementation, and the ECB will need to be integrated into the existing supervisory colleges and Nordic-Baltic financial sector fora. With most of the large Estonian banks headquartered in Nordic countries that are likely to be outside the Banking Union, this may be a challenging process. However, close collaboration between the Estonian authorities, the ECB, and the Nordic authorities will be important to smooth this transition.

Structural reforms and other policy priorities

13. The government should be prepared to respond to further evidence of deteriorating competitiveness from real wage increases. (...)

14. Estonia’s high level of structural unemployment needs to be addressed. (...) 

15. Regional efforts to improve infrastructure links to Estonia’s neighbours could also boost competitiveness. (...)

Full press release

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