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International Monetary Fund
Estonia—2001 Article IV Consultation
Tallinn, April 25, 2001
1. The economic recovery from the recession triggered by the August 1998 Russia crisis gained momentum last year. Real GDP increased by 6½ percent in 2000, driven by a rapid growth of exports, and, in the second half of the year, by strong private consumption. Inflation rose somewhat in the recovery, but was pushed up primarily by the weakness of the euro and the increase of oil prices. Although the external balance in goods and nonfactor services improved substantially in 2000, the external current account deficit widened a little, as profits accruing to foreign investors rose sharply. Importantly, the economic recovery also led to a decline in unemployment from its peak in early 2000.
2. Appropriate economic policies continue to contribute significantly to these favorable developments. Most noteworthy was the impressive fiscal adjustment, with the general government deficit declining from over 4½ percent of GDP in 1999 to less than ½ percent of GDP in 2000. This fiscal correction was essentially achieved through a combination of across-the-board expenditure restraint and increased revenues linked to the economic recovery. As a result, the share of general government spending in GDP declined sharply to about the level obtained before the recession in 1998. This stance of budgetary policy was fully appropriate in the prevailing cyclical and balance of payments situation, and also consistent with Estonia's medium-term strategy. While the growth of money and credit was relatively high throughout 2000, there was no significant pressure on the exchange market, and confidence in the currency board remained strong. All the quantitative performance criteria under the government's economic program were met, many by large margins.
3. Reflecting a slowdown in the growth of foreign demand, economic growth is expected to moderate in 2001, but to remain relatively robust, with real GDP projected to rise by about 5 percent. Although the continuing pass-through of high energy prices and the weakness of the euro is likely to push up average inflation in 2001, the 12-month inflation rate should decline substantially as these effects taper off during the course of the year. The slowdown in export growth is expected to contribute to a slightly higher external current account deficit, despite a move toward budget balance. It is, however, expected that the current account deficit will again be financed mainly by non-debt-creating capital inflows, such as foreign direct investment. Finally, with continued robust economic growth, unemployment should continue to decline, albeit moderately as structural factors dominate developments in unemployment.
4. There are significant potential risks to this near term outlook. On balance, the main risk appears to be a substantial slowdown in Estonia's export markets. This could reduce Estonia's economic growth, widen the external current deficit, and, on account of weaker revenues, turn the fiscal position into deficit. Most importantly, the potential combination of a weaker economy and a widening current account imbalance could require macroeconomic policies to deal with conflicting policy objectives. Under the currency board arrangement, fiscal policy remains the primary macroeconomic policy instrument available, thus requiring potentially a difficult decision on which objective to focus on.
5. The original government target of a balanced budget for 2001 remains appropriate for now in the light of prevailing cyclical and external conditions. Given the risk to the macroeconomic outlook, however, the government needs to monitor the situation closely, and, if necessary, respond to substantial changes in the external prospects. In particular, it would seem appropriate to permit the automatic stabilizers to operate fully in both directions. Achieving a balanced budget in 2001 may require some underspending by the central government relative to budgeted expenditure levels later this year to compensate for a potential budgetary deficit by the City of Tallinn.
6. Based on our current assessment of the cyclical and balance of payments situation, we also support the government's target of a balanced budget for 2002. Should economic growth proceed as currently projected, it would seem appropriate to balance the budget, including the transitional cost of the pension reform, because of the large private sector savings-investment imbalance. It is, moreover, important to base the budget for 2002 on cautious revenue assumptions, and the initial economic projections may need to be revisited should growth slow more than anticipated.
7. We welcome that the government has prepared medium-term budgetary projections in the context of drafting the Preaccession Economic Program (PEP) for the EU. We offer the following observations:
(i) the aim of broad budget balance over the medium term seems appropriate. A budget deficit would not be desirable because it would add to the already high current account deficit, which mirrors the large private sector savings-investment imbalance;
(ii) the projection of a significant declining trend in the revenue-to-GDP-ratio in the absence of tax policy changes appears overly cautious, particularly in the outer years. We would encourage showing explicitly in the PEP projections how EU accession-related expenditures can be accommodated. We believe that this can be achieved without tax increases, abandoning the target of a balanced budget, or cutting other governmental outlays in real terms.
8. Money and credit aggregates have risen briskly throughout 2000 and in the first quarter of 2001. Unless there is a tendency for this growth to moderate, the Bank of Estonia should stand ready to take measures aimed at reining in the growth of credit aggregates. Moral suasion can be helpful, and we welcome the dialogue between the BoE and commercial banks on this issue. Further measures could entail the shifting of government deposits abroad to tighten banks' liquidity, and a tightening of prudential standards on consumer credit and leasing.
9. The prospective merger of two Swedish banks would seriously affect the Estonian banking sector. We fully support the Bank of Estonia's decision not to allow a merger of Hansapank and Ühispank, or for those banks to be controlled by a single foreign investor, as this would create de jure or de facto a bank with a very dominant market position, controlling almost 90 percent of total assets of the Estonian banking system. We are also pleased to note the further progress made in financial market supervision with the Bank of Estonia now closer to full compliance with all Basle Core Principles. Legislation to establish the Financial Supervisory Agency, with operational and budgetary independence, is also expected to be passed shortly.
10. Estonia continues to be at the forefront of the transition process. The trade system has remained among the most liberal in the world. Privatization of the few remaining public enterprises also continues. Care, however, needs to be taken that this process be transparent, so as not to undermine public support for it. It is disappointing that the new organic budget law has not yet been passed by parliament. Passage of this law is the key recommendation emerging from the work of the recent mission preparing the fiscal transparency report on the observance of standards and codes (ROSC). We urge the government to ensure that the new law will be in place to apply to the 2002 budget. We also support the government's efforts to rationalize the structure of local governments, which eventually should help improve control over public expenditure and reduce administrative costs. It would be unfortunate if these reforms were to be delayed.
11. Estonia has very liberal labor market policies. Although unemployment has declined somewhat in the economic recovery, it has remained stubbornly high. A skills mismatch and limited geographical mobility appear to be the main reasons for persistently high unemployment, leading to the growing share of long-term unemployed, and the geographical concentration of unemployment. Active labor market policies, such as targeted training programs, may help in the shorter term, while a reorientation of the educational system could help in the longer run. The authorities should, however, guard against adopting more rigid labor policies, as labor market flexibility remains crucial under a currency board. We welcome the government's efforts to strengthen the social safety net through reforms of the pension system and new unemployment insurance legislation. At the same time, these reforms will add to already high payroll taxation. The government, therefore, should consider cutting social security taxes, or increasing the threshold for the personal income tax, when the budgetary situation permits such a step. This may, however, not be possible in the near term and may require cutting back on less essential budgetary outlays.
12. Estonia continues to be at the forefront of transparency of public policy making. We welcome the intention to again publish the Article IV report, as well as the Reports on the Observance of Standards and Codes (ROSC) on fiscal transparency and data quality.
13. The current Stand-by Arrangement expires at the end of August. We understand that the authorities do not intend to seek a new arrangement. We, however, look forward to continuing to work closely with the Estonian authorities in the future, including on issues related to EU accession and budget preparation.