Public Information Notice: IMF Concludes Article IV Consultation with Estonia

July 1, 1999

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 June 24, 1999, the Executive Board concluded the Article IV consultation with Estonia1.


Since regaining its independence in 1991, Estonia has consistently pursued strongly market and stability oriented economic and financial policies, including an open tariff-free trade policy, full convertibility for current and capital account transactions, a currency board tying the exchange rate for the kroon to the deutsche mark, and an active privatization program that has resulted in the transfer into private ownership of virtually all state-owned enterprises. The combination of conservative financial policies and a strong commitment to structural reform created the conditions for an early recovery of output growth (beginning in 1995) and a decline in the inflation rate.

After increasing by nearly 12 percent in 1997, real GDP growth slowed to 4 percent in 1998. Tighter macroeconomic policies (introduced in late 1997 as part of the program supported by the Fund), the decline in the stock market, and banking difficulties in the wake of the Russia crisis in August 1998 dampened domestic consumption and investment. Output growth in early 1999 has remained weak. Overall, the direct impact of the Russia crisis on growth was relatively modest, mainly because Estonia had reoriented most of its trade to the West and the exposure of Estonian banks to Russian financial markets was limited.

Inflation continued to abate in 1998 and early 1999, with the 12 month CPI inflation falling to 3.6 percent in April 1999. The weakening of domestic demand combined with continued good export performance resulted in a marked improvement in the current account deficit, which narrowed from 13 percent of GDP in 1997 to 8 ½ percent of GDP in 1998. This deficit was financed mainly by foreign direct investment, which reached 11 percent of GDP in 1998, due largely to major purchases of Estonian bank shares by Swedish banks. Net official external debt, at around 1 ½ percent of GDP at end-March 1999, remains very low.

After a large surplus in the first half of 1998, the general government's fiscal position weakened significantly in the second half as revenue collection fell short of expectations because of the slowdown in the economy. Although nominal expenditure targets were only moderately exceeded, the sharp decline in the inflation rate resulted in real government expenditures increasing substantially, reflecting, inter alia, new public investment, compensation for depositors of a failed bank, and support for agriculture, which had been seriously affected by the Russia crisis and poor weather. As a result, the ratio of general government expenditures to GDP rose and the consolidated budget swung from a surplus of 1.8 percent of GDP in 1997 to a deficit of 0.3 percent of GDP in 1998. In 1998 the government transferred EEK 524 million to its Stabilization Reserve Fund (SRF) from surpluses generated early in the year and, in February 1999, added a further EEK 1,510 million (US$110 million) from the partial further privatization of a telecommunications company. SRF balances -- which are invested in liquid prime assets abroad -- totaled EEK 2.8 billion at end-March 1999 (US$190 million) and are over and above the foreign exchange reserves held by the Bank of Estonia as cover for the currency board.

The currency board and the fixed peg to the deutsche mark (and euro as of January 1, 1999) continued to provide a transparent and credible framework for financial operations and the formation of economic expectations. As foreign funding, which had fueled the rapid credit growth in 1997 tapered off, the growth of broad money slowed to 7 percent in 1998. Consolidation in the banking system continued, with the number of licensed banks falling from 11 to 5 in 1998 as a result of mergers involving four major banks and the failure of three smaller ones. The purchase by two major foreign banks of substantial shares in the two largest Estonian banks during the second half of 1998 provided both fresh capital and management expertise. The Bank of Estonia continued to improve banking supervision in 1998. The passage of a new law on credit institutions in February 1999 will materially strengthen the central bank's authority in exercising its supervisory functions. The new Deposit Insurance Law, which became effective on October 1, 1998, provides important protection for bank clients and further strengthened confidence in the domestic banking system.

The government's medium-term economic program is to (i) restrain budgetary expenditures and to enhance revenues through improved administration with the aim of achieving substantial budget balance from 2000 onward, (ii) maintain the currency board and current exchange rate peg until Estonia joins the European Monetary Union, and (iii) proceed with the implementation of second generation structural reforms, including pension and health sector reforms, and the resolution of complex economic, social, and environmental issues associated with the energy and oil shale mining sector.

Executive Board Assessment

Executive Directors welcomed Estonia's progress in narrowing the external current account deficit, reducing inflation, and implementing essential structural reforms. However, Directors noted that the economy had slowed significantly in 1998-and appears to have contracted in early 1999-largely because of the situation in neighboring countries and related banking system difficulties. Partly as a result, a fiscal deficit had emerged in the second half of 1998 and was likely to widen in 1999. Directors recognized that the immediate difficulties in the banking system had now been successfully overcome, and considered that Estonia's economy was well positioned for a recovery. Nevertheless, they stressed the need for the authorities to strengthen public savings to avoid any permanent weakening in the fiscal position. They also favored accelerating the implementation of the remaining structural reforms which, they considered, should result in a reduction of the overall size of the government in relation to the economy. They noted that further steps in many of these areas would be required as part of the conditions for qualifying for European Union membership.

Directors were concerned that unrealistic growth and revenue projections, coupled with real increases in pensions and budgetary wages of 20 percent and some one-time factors, had led to a sharp widening of the fiscal deficit in early 1999. They welcomed the expenditure cuts envisaged in the supplementary budget, which would assist in offsetting this deterioration. They also welcomed the intentions of the new government to aim at a balanced budget for 2000. As regards fiscal adjustment in a longer term perspective, Directors were of the view that the emphasis should be on additional spending restraint, inter alia by increasing the efficiency of government operations.

Directors took note of the rapid changes in the Estonian banking system. They agreed that inadequate risk management had accompanied the rapid growth of bank lending in 1997, which had been fueled by foreign funding. Directors considered that the banking system had been very substantially strengthened by its recent consolidation, including bank closures and mergers, and by the large participation of foreign strategic investors. They supported the ongoing strengthening of banking supervision and the authorities' intention to improve the supervision of the insurance and leasing sectors. They urged the Bank of Estonia to sell its shares in Optiva Bank as quickly as possible.

Directors noted that exports had continued to grow rapidly in 1998, and that the reduced current account deficit had been more than covered by foreign direct investment. They nevertheless considered that further reduction over the medium term in the still relatively high current account imbalance would be warranted. In this connection, and while recognizing that the traded goods sector remained competitive, Directors stressed the need for continued labor market flexibility and strong budgetary performance.

Directors welcomed the stable and predictable framework provided by the currency board and viewed the fixed exchange rate peg to the deutsche mark (and now the euro) as appropriate. They commended the fact that Estonia's exchange and trade systems were free of restrictions, which had supported the rapid restructuring of the economy and an efficient resource allocation.

Directors considered that Estonia has made excellent strides in essential structural reforms. The reliance on strategic foreign investors in the privatization process had resulted in the rapid transfer of management skills and technology, in strong corporate governance, and the development of close ties with export and capital markets. Directors supported the authorities' intention to privatize the few remaining large, infrastructure-related, state enterprises. They encouraged the authorities to continue to transfer most privatization revenues to the Stabilization Reserve Fund, and to create a clear legal basis for the operation of this fund. They also urged the authorities to establish an appropriate framework for profit transfers from the Bank of Estonia to the budget.

Directors welcomed the progress already made in preparation for European Union membership. They noted that, to a considerable extent, the agenda for further structural reform would be driven by considerations related to European Union membership. Directors recognized that more time would be needed to finalize plans, but urged the authorities, in formulating the next stage of reforms, to give careful consideration to the longer term budgetary implications of European Union membership, to health and pension reforms, to the need to phase out remaining administered prices, and to the complex economic, social, and environmental issues related to electricity generation and oil shale mining.

Directors commended Estonia's transparency regarding policy decisions and the publication of high-quality and timely statistical data and other economic and financial information. They welcomed Estonia's participation in the pilot project for the publication of staff reports.

Republic of Estonia: Selected Economic Indicators

1994 1995 1996 1997 19981

Real Economy Changes in percent
Real GDP -2.0 4.3 4.0 11.4 4.0
CPI (period average) 47.7 28.9 23.1 11.2 8.2
Unemployment rate (in percent) 7.6 9.7 10.0 9.7 10.3
Domestic saving2 20.3 22.3 17.8 17.9 20.5
Domestic investment2 27.6 26.7 27.5 30.8 29.1
Public Finance In percent of GDP
General government balance 1.3 -0.5 -1.5 1.8 -0.3
General government debt3 7.3 6.7 6.9 4.7 3.3
Money and Credit Changes in percent
Base money 11.5 19.1 21.6 37.7 6.4
Broad money 29.6 31.3 36.8 37.8 6.6
Domestic credit to nongovernment 57.0 54.0 70.0 83.9 14.3
Balance of Payments In per cent of GDP
Trade balance -15.5 -19.2 -24.0 -25.1 -21.4
Current account -7.3 -4.4 -9.7 -12.9 -8.6
Gross international reserves
(in millions of US$) 447 583 640 760 813
Exchange Rate
Exchange rate regime Currency Board Arrangement
Present EEK 8 = DM 1
Real effective exchange rate  
(1995=100) 85.5 100.0 108.0 115.1 153.8
Of which: Non-CIS related 113.9 133.2 144.3 153.4 169.3

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

1Staff estimates.
2In percent of GDP.
3Net of general government deposits abroad.

1Under 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 directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion are described.


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