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IMF Survey: Inflexible Budget Curbs Options as Estonia Faces Recession

April 15, 2009

  • Estonia's economic downturn exacerbated by global slowdown
  • Fiscal position has to improve significantly to qualify for euro adoption
  • Flexible labor market key to enhance external competitiveness

Estonia is experiencing a severe economic downturn brought on by mounting internal and external imbalances.

Inflexible Budget Curbs Options as Estonia Faces Recession

Textile plant in Tallinn, Estonia, where relatively flexible labor markets are helping during economic turmoil (photo: Attal Serge/Corbis Sygma)


These preceded, but are being exacerbated by, the global downturn.

A previous run of strong growth and prudent macroeconomic and financial policies has produced substantial fiscal and financial sector buffers which, along with relatively flexible labor and product markets, are helping the country weather the current turmoil. The task for policymakers now is to reestablish the basis for balanced economic growth, external sustainability, and euro adoption, the IMF said in its regular review of Estonia’s economy.

The Estonian economy grew by 7 percent on average during 2000–07, supported by liberal economic and generally conservative fiscal policies. These policies underpinned Estonia’s currency board arrangement, which also anchored low inflationary expectations. They also facilitated rapid international financial integration. As a result, real per capita incomes converged quickly with those of European neighbors and now stand at about two-thirds of the EU average.

Growing economic imbalances

This strong performance was eventually undermined by widening macroeconomic imbalances, and an erosion, albeit moderate, of competitiveness. The external current account deficit topped 18 percent of GDP in 2007.

These imbalances were financed through a combination of large foreign domestic investment inflows, as well as rising external liabilities that topped 120 percent of GDP in 2008 and were incurred almost entirely by the private sector. A good deal of this debt was owed by foreign-owned bank subsidiaries to their parents abroad and was used to finance rapid domestic credit growth.

Estonia now faces a severe recession. While in part initiated by the desire of Nordic banks—which dominate the local market—to reduce their Baltic exposures, the downturn fed on its own imbalances, and gained momentum from the global financial crisis. The economy contracted by 3.6 percent in 2008, and IMF staff projects a further 10 percent fall in 2009.

The current account deficit has declined appreciably. Inflation is falling rapidly, slowing to 2 percent in March, while unemployment rose to 7½ percent at end-2008. A rebound in activity is not expected before late 2010. However, the outlook remains uncertain given the global turmoil and Estonia’s reliance on exports.

Substantial fiscal reserves

Strong economic growth and low expenditure ratios by EU standards had supported fiscal surpluses, and allowed for the accumulation of substantial reserves—at about 10 percent of GDP at end-2007. This distinguishes Estonia from its Baltic neighbors. But the above-capacity growth also buoyed revenues and financed sizable increases in the wage bill and pensions in 2007–08.

As the economy slowed and revenues declined, government accounts were driven into a deficit of 2.4 percent of GDP—the first deficit in almost a decade—with larger shortfalls projected thereafter. This jeopardizes the authorities’ goal of meeting the Maastricht 3 percent-of-GDP deficit criterion necessary for euro adoption. Moreover, a high degree of budget inflexibility, with 70 percent of central government expenditures driven by entitlements and tax earmarks, handcuffs policy options.

But with a debt burden of only about 5 percent of GDP, fiscal sustainability is not in question. Nevertheless, current market conditions place pressures on the use of present fiscal buffers, and the longer-term fiscal imbalance needs to be sustainably addressed.

Asset-quality issues

Estonia’s banking system, which is almost entirely foreign owned and to date quite profitable, also faces asset-quality issues. Banks’ access to their parents’ support and confidence in the currency board have facilitated rapid financial deepening—but also led to a buildup of a large loan portfolio, much denominated in foreign currency.

The share of nonperforming loans remains remarkably small, and sizable bank profits allowed institutions to accumulate comfortable financial buffers. But they face increasing risks, especially as asset quality is being eroded by the recession, and confidence is sensitive to events in the region.

Estonian policymakers have responded primarily with measures aimed at improving public finances, where further actions may be necessary. The 2009 budget attempted to address the authorities’ near-term goals of maintaining their fiscal buffer and meeting the Maastricht deficit criterion, but was overtaken by events.

Supplementary budget

The rapidly worsening economic outlook prompted a supplementary budget in February 2009, including expenditure cuts of an additional 3¼ percentage points of GDP. The government has expressed its resolve to undertake additional measures, as necessary, to keep the budget deficit under the Maastricht ceiling. Reducing the growth of current expenditures will be key in this regard.

Financial sector resilience is being boosted as well. Most importantly, an emergency liquidity assistance facility has been agreed between the central banks of Estonia and Sweden, providing the two largest banks, which are Swedish owned, with access to liquidity if necessary. The bank resolution framework is being strengthened through legislation under preparation.

Labor market flexibility

In addition, policies have been adopted to further improve labor market flexibility. While labor and product market flexibility are already comparatively high, legislation that was formulated before the downturn is to take effect in mid-2009 to reduce layoff costs, align the labor law with private contract law, streamline procedures, and simplify conflict resolutions.

At the same time, the social safety net is to be strengthened by increasing unemployment compensation benefits, which is crucial in light of the downturn but may be postponed for budgetary reasons.

As elsewhere, the Estonian economy’s flexibility and resilience are now being tested even more than during the 1998 Russian crisis. The authorities have chosen to tackle them within the currency board arrangement, which has served Estonia well, although euro adoption would provide a more secure setting.

With inflation falling, a strengthening of the fiscal position to continue to meet the Maastricht criterion is appropriate, as well as to secure longer-term sustainability. The financial sector has weathered pressures thanks to large buffers and supportive policies. Further enhancing an already flexible labor market should support the response to the current downturn and to maintain external competitiveness—vital to contain the growth of external indebtedness.

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