Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with the Republic of Estonia

July 30, 2007

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. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2007 Article IV Consultation with Estonia is also available.

Public Information Notice (PIN) No. 07/88
July 30, 2007

On July 23, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Estonia.1


Estonia's commitment to prudent macroeconomic policies and regional integration has resulted in the fastest convergence among new European Union member states and an impressive rise in living standards. After more than a decade of remarkable growth, the economy is now overheating and facing increased regional uncertainties.

Rising incomes, the favorable investment climate, and low-interest financing have fueled an investment and consumption boom that has generated double-digit real GDP growth, widened the external current account deficit, and driven inflation into the 5-6 percent range, well above the Maastricht threshold for euro adoption. Domestic growth and employment opportunities in the EU have tightened the labor market—the unemployment rate has fallen sharply in the past two years to a post-transition low of less than 6 percent—and increased labor costs. Real wage increases have overtaken productivity growth in the past year, pushing up real unit labor costs and threatening external competitiveness.

The external environment has turned less benign as pressures on the Latvian currency earlier this year put a spotlight on financial vulnerabilities in the region. To date, Estonia's track record of sound macroeconomic and prudential policies has helped it brush off contagion effects of these developments. But the intensified scrutiny from market observers has increased the cost of policy slippage.

There are some signs of an incipient moderation of demand growth. The housing market has cooled—prices are already unaffordable for many households and interest rates are rising. The flow of credit has slowed—the major banks have reassessed risks and tightened lending conditions. And, more broadly, market sentiment has shifted in apparent recognition that the recent pace of income growth is not sustainable.

Estonia's long-standing commitment to fiscal prudence—a track record of surpluses and the near-elimination of government debt—was underscored in 2006 by a large fiscal surplus and an associated negative fiscal impulse. Looking ahead, the government is committed to keeping fiscal policy tight and is targeting budget surpluses of 0.7 percent of GDP in 2007 and 0.5 percent of GDP in 2008-11.

The banking sector is strong: banks are well capitalized, profitability is high, and non-performing loans are negligible. Given that all major Estonian banks are affiliates of much larger foreign institutions, the financial supervisor and central bank are strengthening cross-border cooperation in supervising banks and developing crisis management procedures.

Executive Board Assessment

Executive Directors commended Estonia's impressive convergence toward EU living standards, underpinned by prudent macroeconomic management, far-reaching structural reforms, and strong regional integration. They noted that this solid foundation should also help Estonia address the near-term challenges of steering the economy toward a soft landing and sustaining credibility in the face of regional financial uncertainties.

Directors concurred that tight fiscal policy is needed to address macroeconomic overheating and the attendant risks. They commended the authorities for the strong fiscal outcome in 2006 but saw some need for further strengthening of the 2007 fiscal position given the continued overheating. Directors in particular recommended limiting any procyclical impulse by at least refraining from new spending in the 2007 supplementary budget.

Looking forward, Directors underscored the importance of a tight fiscal policy to contain household optimism and prepare for the costs of an aging population. They welcomed the intent to target budget surpluses instead of balanced budgets but noted that the signal sent by the budget strategy would be clearer if the specified floors were more ambitious given the significantly larger surpluses achieved in recent years. The authorities were also encouraged to implement, for the state-funded pillar of the pension system, a pension indexation rule that limits ad hoc increases in benefits while ensuring adequate living standards for pensioners relative to those of workers.

Directors noted that the banking sector appears strong and buffers in the financial system seem sufficient. Nonetheless, they cautioned that the rapid growth of credit in the past few years calls for continued vigilance in financial supervision, including a more systematic use of stress tests. Directors encouraged the authorities to extend and strengthen cross-border supervision as the region moves to Basel II in 2008. They emphasized that close cooperation with the Nordic authorities is essential, given Estonia's mostly Nordic-owned banking sector. Directors welcomed the existing good cooperation with the other Nordic and Baltic financial supervisors and the recent steps to deepen that relationship.

Directors agreed that euro adoption at the earliest possible date should remain a key objective given that, despite the robust currency board arrangement, currency risk will not be eliminated altogether until the euro is adopted. They thus welcomed the new government's reaffirmation of Estonia's commitment to euro adoption.

Noting some signs of weakening competitiveness, Directors emphasized that labor and product market flexibility are essential for macroeconomic stability under the currency board arrangement and, in time, euro area membership. In this regard, they welcomed the efforts to review and update the labor code, and encouraged the authorities to preserve Estonia's business-friendly environment by keeping administrative and operating costs low.

Republic of Estonia: Selected Economic Indicators
  2002 2003 2004 2005 2006  

Real Economy

In units as indicated  

Real GDP growth, in percent

8.0 7.1 8.1 10.5 11.4  

Average CPI inflation, in percent

3.6 1.3 3.0 4.1 4.4  

Unemployment rate (ILO definition), in percent

10.3 10.0 9.7 7.9 5.7  

Domestic saving, in percent of GDP

21.7 21.4 23.6 24.8 23.3  

Domestic investment, in percent of GDP

32.4 33.0 36.2 35.2 38.2  

Public Finance

In percent of GDP  

General government balance

1.1 2.5 1.6 1.6 3.3  

General government debt


Excluding government assets held abroad

5.6 5.7 5.2 4.4 4.1  

Including government assets held abroad

0.3 -2.5 -2.8 -3.1 -5.0  

Money and Credit

Changes in percent  

Base money

-1.5 14.6 24.0 33.0 30.7  

Broad money

11.2 10.9 15.8 41.9 28.2  

Domestic credit to nongovernment

27.8 27.0 31.2 33.4 41.6  

Balance of Payments

In percent of GDP  

Goods and non-factor services balance

-7.1 -7.7 -8.1 -6.2 -10.3  

Current account

-10.6 -11.6 -12.5 -10.5 -14.8  

Gross international reserves (euro, millions)

958 1098 1317 1647 2128  

Exchange Rate


Exchange rate regime

Currency Board Arrangement  

Exchange rate parity


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

106.8 109.9 113.9 113.3 117.2  








Sources: Estonian authorities, and Fund 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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