Mission Concluding Statement 

Tallinn, March 12, 2014¹

1.  Estonia’s recovery from the crisis continued in 2013 but at a slower pace. Preliminary data indicate that growth was 0.8 percent 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 labor market and other indications of more rapid growth. Tax collections are up in real terms, and real wages and unit labor costs have been rising over the last couple of years as unemployment has declined. Unemployment is now at or below most official and external estimates of structural (or natural) unemployment, suggesting that additional fiscal stimulus may be more likely to result in increased inflation rather than reduced unemployment.

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 labor costs.

5. Fiscal policy has remained conservative throughout the cycle. The deficit never exceeded 3 percent 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 capitalized, 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 percent in 2014 supported by both external and domestic demand and then rise toward expected potential growth of 3 to 3.5 percent 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 percent 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. Continued contraction in Finland, or lower-than-expected growth in Sweden or Latvia could slow Estonia’s growth through lower exports or FDI. Trade or other shocks from Russia and other CIS countries could also drag down exports or otherwise depress growth. Aside from trade and investment shocks, a rise in interest rates from a shock in the Nordic banking system would pass through quickly into household debt service, and this could lower consumer demand. Finally, labor market overheating already seems evident as real wage growth is exceeding productivity growth, and this could undercut competitiveness and export growth. On the upside, higher than expected growth in Nordic-Baltic countries or other trade partners could also boost Estonia’s growth.

Fiscal policies

9. The 2014 budget continues the Estonian tradition of prudent fiscal policy. The projected headline deficit of 0.4 percent 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 percent. 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 requirement for a structural surplus should prevent increases in expenditure during good times that cannot be sustained over the longer-term. While adherence to the structural surplus target would not require counter-cyclical spending during downturns, it provides scope to allow automatic stabilizers to operate fully. 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 percent 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. While the first of three roughly 10 percent annual increases in the minimum wage in 2013-15 probably had minimal effect on average wages, the two subsequent increases may not be as benign. Also, while wages are very largely market determined in Estonia, the minimum wage increases and public health and education wage increases may have had a demonstration effect beyond their direct impact. Until it is clear that recent signs of worsening price competitiveness are not undercutting net exports, the government should refrain from large public sector wage hikes or agree to minimum wage increases after 2015.

14. Estonia’s high level of structural unemployment needs to be addressed. Estonia has a very flexible labor market, but skills mismatches and wage tax levels seem to be keeping unemployment high even in good economic times. Some active labor market policies to address skills mismatches and keep people in the labor force are already in place. The work of the Unemployment Insurance Fund on training and counseling to encourage effective labor force participation by youth, the disabled, and the long-term unemployed has been expanded very substantially to integrate these more difficult segments of the working age population. More efforts are needed to change the composition of specialization in secondary and tertiary education, but this is inherently a long-term project. Finally, labor taxes are high in Estonia, particularly on low-wage workers, and this may be discouraging hiring. Evidence from other countries suggests that reducing the labor tax wedge would be likely to reduce structural employment. In this context, lowering the tax wedge on lower-wage workers should be given serious consideration. The fiscal costs could be offset by tax reforms (e.g., elimination of regressive tax exemptions or the introduction of property taxes) that preserve the fiscal targets. Lowering the tax wedge would also contribute to containing unit labor costs and improving competitiveness.

15. Regional efforts to improve infrastructure links to Estonia’s neighbors could also boost competitiveness. Infrastructure in Estonia is rated highly in international comparisons, but regional cooperation needs to be enhanced for some critical systems. While progress has been made in linking the electricity grid to Finland, more could be done to build rail links to the rest of the EU and expand options for natural gas supply. Particularly as EU funds are potentially available to finance most of the costs for rail and gas, Estonia should coordinate with its Baltic and Nordic neighbors to better connect itself to the rest of the EU and diversify infrastructure links to be able to take advantage of better opportunities and protect itself against shocks.

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The IMF Estonia team is grateful for the very warm welcome extended to us by the Estonian authorities and members of the private sector, and especially for the very constructive and interesting discussions.

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¹ Mission Concluding Statements describe the preliminary findings of IMF staff at the conclusion of Article IV and other missions.