IMF Executive Board Concludes 2006 Article IV Consultation with the Republic of Estonia

Public Information Notice (PIN) No. 06/134
November 22, 2006

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On November 17, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Estonia.1


Estonia's commitment to free markets and prudent financial policies has paid off handsomely. Far-reaching structural reforms have created a well-functioning market economy, closely integrated with the Baltic and EU regions. A solid currency board arrangement (CBA) and prudent fiscal policy have brought price stability and low public debt. These policies have borne fruit with impressive productivity growth and a corresponding rise in real per capita income—the strongest convergence among the EU's new member states.

This very success is creating new challenges, including an overheating economy marked by tightening labor markets, rising inflation and a wide current account deficit. GDP growth rose above 10 percent in 2005 and is expected to continue at about the same rate in 2006. Domestic consumption, spurred by rising confidence, was the main driver of demand, though exports were also robust. Import growth has been even larger, however, further widening an already large current account deficit. On the supply side, growth has been supported by productivity increases which have, so far, kept up with real wages, and a surge in employment which has brought unemployment to a record low.

The inflation rate—about 4½ percent annual average—is moderate for a fast-converging economy but has been kept higher than the Maastricht threshold by convergence effects, fuel prices, and, more recently, rising nontradables inflation—another symptom of overheating. With the other Maastricht criteria satisfied by comfortable margins, inflation is the main obstacle to euro adoption.

While the government budget has been in surplus for the last five years, the fiscal stance is expansionary because strong revenue growth, partly reflecting cyclical influences, has been matched by expenditure growth, including through supplementary budgets. The draft 2007 budget would loosen the fiscal stance further, with the general government surplus estimated to fall from 1.2 percent of GDP to 0.9 percent.

Economic growth has been associated with rapid credit growth, largely financed by Nordic banks through their Estonian affiliates. The banking system is financially sound, with high profitability and almost nonexistent bad loans. Nonetheless, in view of accelerating credit, highly concentrated in real estate, the authorities have recently taken prudential measures aimed at increasing risk buffers and have signaled concern about the risks of very rapid credit growth.

Executive Board Assessment

The Executive Directors commended Estonia's impressive convergence towards EU living standards, which is founded on a well-functioning and flexible market economy and on macroeconomic stability, anchored in a currency board arrangement (CBA) and a commitment to fiscal balance or surpluses. They noted that this success is giving rise to new challenges. Growth has risen above potential and the external current account deficit is widening. Strong demand is putting pressure on wages and prices, which could weaken competitiveness, while fast credit growth could compromise banks' assessment and pricing of risk. And, inflation, while moderate, remains above the Maastricht reference value, delaying euro adoption. Directors concurred that addressing these challenges will be key to sustaining the economy's enviable performance.

Directors commended the authorities for their commitment to fiscal rectitude. The surpluses projected for 2006 and budgeted for 2007 are welcome. However, they appear too small, implying an expansionary fiscal stance at a time when overheating pressures, higher-than-desired inflation, and a wide external current account deficit call for a tighter fiscal stance. Under these circumstances, it would be advisable to save the revenue overperformance in 2006, and plan for at least a neutral budget in 2007 on a cyclically-adjusted basis. Directors also emphasized that the exceptionally strong economic growth provides a welcome opportunity to reduce the share of government expenditure in GDP and address the challenges stemming from an aging population.

Directors observed that EU funds are complicating fiscal policy by providing an additional stimulus. They congratulated the authorities on their effective procedures in allocating structural EU funds, but cautioned that budget planning, including for the use of these funds, needs to take into account their macroeconomic impact, particularly in overheated sectors. In addition, Directors suggested that the authorities could lessen the pressure in overheated sectors by easing restrictions on foreign labor participation. At the same time, they also supported continued efforts to reduce skill mismatches, including through human capital development.

Directors welcomed the progress in implementing a medium-term budgeting framework and urged the authorities to eliminate the bias towards procyclical fiscal outcomes. This can be achieved by moving the focus of fiscal policy targeting from the overall balance to expenditure growth, allowing the balance to reflect the business cycle. Directors pointed out that significant early steps in this direction would be to focus budget discussions on expenditures and to end the practice of using supplementary budgets to spend cyclical revenue increases.

Directors concurred that early euro adoption should remain a key objective, as it would lock-in the benefits of the currency board arrangement and eliminate the risks associated with a separate currency. While these risks appear small in Estonia, they are increasing as external debt and currency mismatches rise. Accordingly, Directors considered that a modest delay in euro adoption would be easily manageable, but that a long or open-ended delay should be avoided. They encouraged the authorities to adopt a clearly articulated strategy for euro adoption.

Against this backdrop, Directors noted the challenge of meeting the Maastricht inflation criterion, which is the one criterion for euro adoption that is currently not met by Estonia. They concurred that efforts to contain inflation should be seen primarily as a means to firmly entrench macroeconomic stability. Directors considered that a tight fiscal policy will have to be at the core of the disinflation strategy.

Directors noted that Estonia's close financial integration in the region has created a strong institutional basis for financial deepening but puts a premium on cross-border cooperation and supervisory vigilance. While increases in reserve requirements and in the risk weights on mortgages earlier this year have sent an appropriate signal and led to more cushioning for risk, there is little scope for further regulatory measures of this nature. Consequently, Directors encouraged further strengthening of existing links between Estonian and Nordic supervisors to ensure that foreign banks internalize the risks of their Estonian operations. Banks should also be encouraged to improve risk management, including through more rigorous stress tests. Directors welcomed the authorities' plan to reduce mortgage interest deductibility and called for further steps to eliminate all distortionary fiscal incentives for real estate investment.

Republic of Estonia: Selected Economic Indicators

  2001 2002 2003 2004 2005

Real Economy

In units as indicated

Real GDP growth, in percent

7.7 8.0 7.1 8.1 10.5

Average CPI inflation, in percent

5.8 3.6 1.3 3.0 4.1

Unemployment rate (ILO definition), in percent

12.6 10.3 10.0 9.7 7.9

Domestic saving, in percent of GDP

22.9 21.7 21.4 23.6 24.8

Domestic investment, in percent of GDP

28.1 32.4 33.0 36.2 35.2

Public Finance

In percent of GDP

General government balance

0.4 1.1 2.3 1.6 1.6

General government debt


Excluding government assets held abroad

4.5 5.3 5.7 5.2 4.6

Including government assets held abroad

1.2 0.0 -2.4 -2.8 -3.0

Money and Credit

Changes in percent

Base money

-9.8 -1.5 14.6 24.0 33.0

Broad money

23.0 11.2 10.9 15.8 41.9

Domestic credit to nongovernment

22.2 27.8 27.0 31.2 33.4

Balance of Payments

In percent of GDP

Goods and non-factor services balance

-2.1 -7.1 -7.7 -8.1 -6.2

Current account

-5.2 -10.6 -11.6 -12.5 -10.5

Gross international reserves (euro, millions)

930 958 1098 1317 1647

Exchange Rate


Exchange rate regime

Currency Board Arrangement

Exchange rate parity


Real effective exchange rate, end of period, 2000=100 1/

103.4 105.9 109.5 112.1 113.6

Sources: Estonian authorities, and IMF staff estimates.

1/ From INS, export-share weighted CPI real exchange rate against 15 major trading partners.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.


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