Public Information Notice: IMF Concludes 2003 Article IV Consultation with the Republic of Estonia

October 27, 2003

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2003 Article IV consultation with Estonia is also available.

On October 22, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Estonia.1


The rapid and successful transformation of Estonia into an open and flexible market economy places it as a star performer among European Union accession countries. The foundation for this accomplishment is a prudent macroeconomic policy, based on a balanced budget strategy, the currency board arrangement, and vigorous structural reform. The positive outcome of Estonia's national referendum on EU membership paves the way for EU accession on May 1, 2004, solidifying these accomplishments.

The Estonian economy continues to perform very well despite weakness in major export markets. The economy grew by 6 percent in 2002, driven by both strong domestic investment and consumption demand, and recent data suggest that economic activity continued to be buoyant in the first half of 2003. Labor market developments were also positive with higher employment and lower unemployment. Inflation has declined to a new low, reflecting declining import prices and positive "one-off" factors such as lower food prices.

Fiscal performance has been very strong, as rapid growth in domestic demand contributed to higher-than-expected tax revenue. The general government budget showed a surplus of 1.2 percent of GDP in 2002, with the positive balance continuing in early 2003 and allowing for a further buildup of deposits. This has occurred despite several supplementary budgets, a rapid increase in public expenditure, and persistent deficits at the municipal level.

A further easing of monetary conditions contributed to continued strong money and credit growth. Interest rates in Estonia declined as a result of a fall in Euro-area interest rates and a decline in the country's risk premium. Furthermore, some financial institutions started to lend more aggressively to increase their market share, putting additional downward pressure on lending rates, especially in the real estate sector. Lease financing continued to grow especially rapidly. Nevertheless, Estonia's banking system remains financially very sound.

The external current account has deteriorated substantially. While large external deficits, to some extent, are a reflection of the country's growth potential, the sudden jump in the deficit from 6 percent of GDP in 2001 to 12.3 percent in 2002 has rendered the economy more vulnerable to external shocks. The deterioration in the current account is particularly worrisome because it was associated with a fall in Foreign Direct Investment (FDI) coverage. Although preliminary information for the first half of 2003 suggests a renewed increase in FDI coverage, the trend of substantially higher deficits and less-than-full FDI coverage remains. Despite these adverse developments, confidence in the currency board remains strong.

Two important structural reforms have been launched: the introduction of a second pillar in the pension system, which aims at moving from the pay-as-you-go system to a fully-funded defined-contribution system, and the establishment of a new unemployment insurance scheme. The introduction of the second pillar was substantially more successful than anticipated.

Executive Board Assessment

Executive Directors welcomed the results of the recent referendum to join the EU and Estonia's successful transformation into an open and flexible market economy. They hoped that the underpinnings of Estonia's success in the past, especially prudent fiscal policy and resolute focus on structural reforms, will continue to be preserved in the future. Directors considered that the overarching economic challenge in the period ahead will be ensuring lasting convergence with the EU in order to ensure a smooth transition to the euro, while maintaining a sound external position.

Directors were encouraged that, despite continued sluggish demand in Estonia's major trading partners, economic growth remains relatively strong, and the outlook positive. However, given the country's degree of openness, a prolonged slowdown in Estonia's trading partners would ultimately impact exports, consumer confidence, and investment activities. Directors also expressed concern that the large current account deficit -in combination with a simultaneous fall in coverage of the deficit by foreign direct investment inflows-has increased the vulnerability of the economy. While the financing of the current account deficit is unlikely to pose difficulties in the immediate future, a deficit of this size will not be sustainable over the longer term.

Directors commended the authorities for their commitment to a prudent fiscal policy, as reflected in the country's balanced budget policy. However, in light of the large current account deficit, most Directors were of the view that a more proactive fiscal policy is required to maintain macroeconomic stability. Directors recommended that the authorities target a balanced budget over the business cycle rather than on an annual basis. In this context, Directors welcomed the government's announcement that it will not pass a second supplementary budget for 2003, but they stressed that the fiscal surplus in 2003 should be higher than that achieved in 2002. They therefore recommended allowing the automatic stabilizers to operate fully and postponing some planned expenditure increases.

Directors welcomed the authorities' ambitious fiscal policy initiatives for the coming years. However, the plan to lower the income tax rate while simultaneously increasing parents' benefits could undermine the fiscal target, in particular given that expectations for inflows of EU funds might prove to be over-optimistic. Directors cautioned that the circumvention of borrowing limits by municipalities, and the use of non-transparent fiscal transactions aimed at financing increased expenditure without affecting the publicly visible deficit, could compromise Estonia's high standards of fiscal transparency and should be resisted. To relieve budgetary pressures and to eliminate potential distortions in the financial system, consideration could be given to gradually eliminating the tax deductibility of mortgage interest payments and the tax exemption on interest income from bank deposits.

Directors noted that confidence in the country's currency board arrangement continues to be strong. They emphasized that Estonia's joining ERM-II with a fixed exchange rate shortly after EU membership--as the authorities intend--will depend on continued implementation of appropriate fiscal and structural policies.

Directors welcomed the authorities' continued effort to foster the soundness of the financial sector through improved supervision, and commended their efforts to address the strong credit growth through measures such as broadening the base for reserve requirements and promoting good lending practices. However, they emphasized the need to be vigilant and to be prepared to increase prudential requirements on a temporary basis if asset prices, especially in the housing sector, increase sharply.

Directors welcomed the implementation of effective mechanisms to combat money laundering and the financing of terrorism. They noted that legislation has been amended to bring it into line with the latest EU anti-money laundering directives, and that explicit provisions criminalizing the financing of terrorism are now in force.

Directors were encouraged by the recent decline in unemployment, but noted that the unemployment rate remains high, especially in the northeastern part of the country. They encouraged the authorities to further improve labor market regulation, facilitate labor mobility, and increase investment in human capital, in terms of both general education and vocational training.

Directors commended the authorities for being at the forefront of efforts to promote data transparency and dissemination. Estonia subscribes to the Fund's Special Data Dissemination Standard and provides key data for surveillance on a timely basis.

Republic of Estonia: Selected Economic Indicators








Real Economy

Changes in percent

Real GDP






CPI (period average)






Unemployment rate (in percent) 1/






Domestic saving (in percent of GDP)






Domestic investment (in percent of GDP)







Public Finance

In percent of GDP

General government balance






General government external debt


Excluding government assets held abroad






Including government assets held abroad







Money and Credit

Changes in Percent

Base money












Broad money






Domestic credit to nongovernment







Balance of Payments

In percent of GDP

Goods and non-factor services balance






Current account






Gross international reserves (in millions of euro)







Exchange Rate


Exchange rate regime

Currency Board Arrangement


EEK 15.64664= €1

Real effective exchange rate (1995=100) 2/







Sources: Data provided by the Estonian authorities, and IMF staff estimates and projections.


1/ Based on the definition of the International Labor Organization (ILO).

2/ From INS, export-share weighted real exchange rate (CPI) 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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