Mission Concluding Statements
Republic of Estonia and the IMF
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International Monetary Fund
Estonia-2002 Article IV Consultation
Concluding Statement of the Mission
April 30, 2002
Recent developments and outlook
The Estonian economy has shown remarkable resilience in recent months, despite the slowdown in Estonia's major western European trading partners. Growth has been driven by a strong expansion of domestic demand, especially, investment, which increased rapidly over the second half of 2001. Private consumption was supported by further falls in unemployment, strong wage growth, and-for the first time since the transition process began-rising employment. The weakness in the export sector has been less marked than expected and is concentrated mainly in the electronics processing sector. Many Estonian exporters appear to have adapted rapidly to the changing external environment by re-positioning themselves to take advantage of both the relatively strong growth in central and eastern European and Russian markets, and increasing competitive pressures within the EU where they have been relatively successful in maintaining market share. Inward FDI flows also reached record levels in 2001, providing a further indication of the continued confidence of foreign investors in the Estonian economy.
The outlook for the remainder of 2002 is positive, and we expect real GDP growth in Estonia of about 4½ percent for the year as a whole. The continued strength of domestic demand, higher oil prices, and a number of administered price increases, are likely to limit the extent of any further near-term fall in inflation, with the average increase in consumer prices expected to be around 5 percent in 2002. Net exports are likely to benefit from the anticipated recovery in western Europe, although the current account deficit may widen a little further to about 6¾ percent of GDP following a further increase in profits recorded by foreign companies. This is unlikely to be a cause for concern given the scale of available financing (including the re-invested profits of foreign companies).
As ever, there are risks to this outlook, with particular uncertainty regarding the extent to which some of the factors, most notably the surge in domestic investment, that contributed to growth last year will be sustained through 2002. The economy will also remain sensitive to external developments, especially in the EU. In addition, higher oil prices, although unlikely to have a strong direct effect on the economy, could indirectly affect growth prospects through their impact on the economic performance of Estonia's major trading partners.
Our policy discussions with the authorities were both productive and cordial. They largely focused on the risks and uncertainties in the medium-term. Currently, Estonia's fiscal house is in good order, the result of a long-standing policy of fiscal prudence. It is imperative, if growth is to continue, that this continue to be the case.
The government's budget plans for 2002 are consistent with the emergence of a modest fiscal deficit of around ¾ percent of GDP.1 While this appeared to be broadly appropriate at the time the budget was approved, we believe the outlook for the economy has improved since then-with growth likely to be higher than the 4.0 percent assumed in the budget plans-and that a somewhat tighter fiscal stance could therefore be warranted. We agree with the government that, in the event of higher growth, the automatic stabilizers should be allowed to operate, by using the resulting additional revenues to reduce the size of the fiscal deficit rather than to finance additional expenditures at either the State budget or local government level.
We are concerned about the scale of planned increases in expenditure in 2002, with public spending expected to increase by around 7-8 percent in real terms. The use of extraordinary revenue gains and assets from the Compensation Fund to finance significant increases in recurring current expenditure programs is likely to increase the tensions within the budget in future years, when additional EU and Nato related expenditures will also need to be accommodated. Thus, while we support the government's objective of a balanced budget in 2003, we do not underestimate the difficulty of achieving it. With some increases in expenditure effectively already pre-committed, in part because the full-year impact of this year's supplementary budget will not be fully felt until next year, efficiency savings are likely to be necessary in some areas to avoid the need for tax increases. In this regard, we agree with the government that the increase in pensions in 2003 should be determined solely by the statutory indexation formula. In addition, we encourage the government to review the provision of social benefits to ensure that they are effectively targeted. We also welcome the recent voluntary mergers among a small number of local governments, but continue to believe that a more ambitious rationalization of local government administration and financing could yield significant benefits.
The balanced budget principle has served Estonia well in recent years and has contributed significantly to the establishment of macroeconomic stability. We agree that the government should continue to implement this policy over the medium-term, while responding flexibly to short-term variations in cyclical conditions, by seeking to balance the budget over the economic cycle. This will help to maintain the low level of interest rates which have already contributed significantly to economic growth. It would also avoid adding to risks associated with external imbalances. We continue to believe that, through careful expenditure management, it will be possible to accommodate EU accession and Nato related expenditures within this balanced budget framework without the need for increases in the burden of taxation or significant cuts in government outlays in real terms.
We urge the authorities to approve the Organic Budget Law, which was the key recommendation of last year's IMF Report on the Observance of Standards and Codes (ROSC) regarding fiscal transparency. The new law will enhance the already high level of predictability and transparency of the government's fiscal policy framework. We encourage government to explore further improvements to its budget documentation which were identified in last year's ROSC.
The currency board arrangement continues to serve Estonia well. Given the prospects for membership in the European Monetary Union, we agree with the authorities' intention to maintain the current arrangement.
With respect to credit conditions, given that a further fall in the country' risk premium in the near term is unlikely and that prospects for further interest rate cuts in the euro area have diminished, monetary conditions are likely to be less expansionary and might even tighten somewhat in the remainder of the year. While money and credit aggregates have recently grown at a somewhat lower rate, credit to leasing companies continues to be strong. The authorities should monitor this development closely and, if necessary, be prepared to tighten prudential standards on consumer credit and leasing.
We are pleased with how the Bank of Estonia has implemented the step-wise reduction of the cash reserve requirement in order to bring the ratio closer to that in the EMU. The necessary increase in the liquid asset ratio took place without major liquidity implications and has helped foster financial integration with European money markets. However, we encourage the Bank of Estonia not to hasten further reductions, especially if these were to imply an increase in liquidity that could have inflationary consequences. More generally, the authorities should continue to ensure that the expansion of private credit within the economy, although a natural consequence of the transition process, remains consistent with ongoing domestic and external balance, particularly concerning inflation and the current account.
We commend the authorities on the successful establishment of the new Financial Supervision Authority (FSA). The FSA is now able to conduct an adequate number of on-site inspections and commit sufficient resources to the supervisory work related to the establishment of the second-pillar of the pension system. We encourage the authorities to monitor closely institutions that are currently not supervised by the FSA, such as stand alone leasing companies.
We agree with the authorities' approach toward the establishment of a stable and sound banking system and the integration of local financial institutions with European capital markets. In this regard we welcome the merger of the Tallinn and Helsinki stock exchanges. At the same time, the authorities should eliminate distortions-such as tax exemptions for income from bank deposits-that could impede the balanced development of domestic capital markets. The authorities should also continue to be vigilant and ensure that the high degree of concentration in the banking sector does not curtail small and medium size enterprises from having access to adequate funding.
We commend the authorities in their efforts to combat money laundering and financing of terrorism. They have done all that has been asked and are prepared to do more.
With respect to labor markets, preliminary indications are that labor shedding may be coming to an end. This is an important milestone in the transition process. But unemployment, while decreasing, remains high. We agree with the authorities that unemployment is best addressed by ensuring macro-economic stability and by targeting job training at the unemployed young and the long-term jobless. In its efforts to foster a strong, flexible labor market-something that is particularly important for a country with a currency board arrangement-we encourage the authorities to guard against disincentives arising from the interaction of the tax and benefit system at low income levels.
Recent growth rates in Estonia have been high, perhaps unexpectedly high given the weakness in western Europe. An understanding of the growth process is important if the proper policies are to be followed. Accordingly, we are happy to comply with a request from the authorities to investigate the underlying forces of growth in the Estonian economy.
Estonia has allowed markets to function freely and this has served the economy well. The Estonian experience has demonstrated clearly that a free and open trade regime is a key to strong economic performance. We encourage the authorities to continue to foster the development of free markets and establishment of an investor friendly environment, while refraining from favoring certain sectors or enterprises. At the same time, we note that some small and medium size enterprises may face difficulties in obtaining sufficient financing. These problems can be expected to ease as the economy grows. We are concerned about the use of Kredex-type programs to address this problem. Great care must be exercised to make sure that this type of program is neither abused nor introduces market distortions, and does not give rise to large contingent liabilities for the public sector.
We welcome the authorities' intention to publish again the Article IV report. The transparency of public policy making in Estonia continues to be enviably high. The government is also making welcome progress in further enhancing the already high quality of official data, along the lines recommended in last year's Data ROSC.
1 When measured according to internationally agreed definitions, under which the transfer of assets from the Compensation Fund is regarded as deficit financing rather than as revenue.
IMF EXTERNAL RELATIONS DEPARTMENT