Estonia: Staff Concluding Statement of an IMF Staff Visit
IMF News, July 1, 2019
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- Published: July 1, 2019
Recent Economic Developments
- Real GDP growth averaged 4.1 percent during 2016–18, driven by domestic consumption—supported by rising employment and wages—and a pickup in investment.
- Estimates for industrial production and turnover of retail trade for 2019Q1 point to continued strong activity for the rest of 2019.
- Inflation reached 3.2 percent (y/y) in April 2019, underpinned by recovering energy prices, rises in air fares and drought-related increases in food prices.
- Gross wages increased by 8.9 percent in 2018, outpacing productivity growth of 7.8 percent.
- Unit labor costs rose by 9.5 percent in 2018, faster than in EU peers, raising concerns about medium-term competitiveness.
- Fiscal outturns in 2018:
- Headline deficit of about 0.5 percent of GDP (provisional).
- Structural deficit of 1 percent of GDP (provisional).
- Public debt stock at 7.9 percent of GDP in 2018.
- Structural deficit estimated at 0.2 percent of GDP in 2017 and 0.8 percent of GDP in 2018.
- Cumulative impulse (sum of changes in structural balances) estimated at about 1.1 percent of GDP during 2017-18.
- External sector:
- Current account surplus narrowed to 1.7 percent of GDP in 2018 from 3.2 percent of GDP in 2017.
- Real effective exchange rate appreciated by 3.6 percent in 2018.
- Real estate:
- Transactions slowed by 1.6 percent (y/y) in 2018, compared to an increase of 8.2 percent (y/y) in 2017.
- Real estate index house prices increased by 5.7 percent in 2018, after 7.7 percent in 2017.
- Banking sector:
- Mostly Nordic-owned, well capitalized, liquid, and profitable.
- AML/CFT-related risks (mostly from the past) are adversely affecting share prices and funding costs for parent banks.
- Investigations at Swedbank; Danske bank branch license revoked (branch will formally wind-down operations in October 2019[1]).
Near-term Outlook and Risks
- Growth and inflation projections:
- Real GDP growth projected at 3 percent in 2019.
- Inflation expected to reach 2.8 percent by end-2019.
- Growth projected to ease to 2.8 percent in 2020 and converge to potential over the medium term.
- Inflation could edge down to 2.8 percent in 2020 and slow further subsequently.
- Risks tilted to the downside:
- External: intensification of trade tensions and weaker growth in advanced economies and major trading partners; tighter financing conditions in Nordic countries.
- Domestic: policy implementation risks (including second pillar pension reforms), constraints to economic immigration, risks of overheating and inflationary pressures, and tighter labor market pressures on wages and competitiveness.
Policy Options — Overview
- Context: output above potential, real interest rates low for the foreseeable future, and weak productivity.
- Fiscal policy is expected to bear the bulk of rebalancing the policy mix.
- Structural reforms to enhance productivity and macroprudential policies to maintain financial stability are recommended complements.
Fiscal Policy — Findings and Recommendations
- Mission reiterated staff advice to move toward a more neutral fiscal stance while safeguarding spending on potential growth and productivity-enhancing investments: infrastructure, research and development, innovation, education, health and training.
- Staff supports:
- Deferring less critical investment projects and rationalizing current expenditures.
- Reviewing the public investment portfolio based on efficiency.
- Maintaining/increasing investment in research and development (authorities decided to maintain R&D at 0.7 percent of GDP; staff supports raising it further).
- Reducing excise and alcohol tax levels to a reasonable level to mitigate disruptive cross-border tax effects.
- Concerns on fiscal stance:
- Fiscal deficits of the magnitude observed exceed the allowable threshold based on previous surpluses of 0.5 percent of GDP.
- The new ruling coalition’s proposed change to the fiscal rule would give room for additional spending; staff emphasizes criticality of observing a more neutral fiscal stance with measures reversing recent loose fiscal outturns.
Pension Reform (Second Pillar) — Issues and Staff Advice
- Authorities’ proposals under consideration:
- Increase state pensions and make participation in the second pillar voluntary in a phased manner.
- Allow individuals to withdraw accumulated funds with an option to place them in a preferred investment account.
- Allow opt-out of the second pillar with payments to the first pillar to partly finance state pension increases.
- Possible reopening of the second pillar to target new entrants.
- Staff concerns:
- Reform could remove some minimum rate of return for defined contribution participants.
- Clear budgetary implications despite second pillar being in principle private.
- Opt-outs could increase future public assistance needs if first pillar savings are insufficient.
- Given Estonia’s aging population, current reform would increase burden on future generations by reducing pension savings.
- Staff considerations/recommendations:
- Proposed measures could generate short-to-long-term fiscal risks, reduce benefits for future pensioners, and possibly downsize or eliminate the second pillar.
- Cashing out balances could boost short-term consumption, fiscal revenue, and growth but reduce future pension entitlements and could make pension scheme managers economically unviable.
- Replacing second pillar with personal pension accounts could expose individuals to investment risks and higher costs, imposing welfare losses.
- Staff supports conducting an in-depth assessment of the current pension system and only embarking on a new structural pension reform if all other options are exhausted and a broad-based agreement is achieved.
- Staff strongly supports a workshop on pensions system reforms to be held very soon given the macro-criticality of the issue.
Structural Policies
- Education and skills:
- “Estonia 2020” reforms focus on aligning education outcomes with labor market needs: vocational training, higher education, life-long learning.
- Progress noted, but capacity still lags labor needs for upskilling and retooling.
- Upcoming efforts for more targeted research and development spending.
- Labor supply and demographics:
- Unemployment rate reached 4.7 percent in 2019Q1 (compared to 7.7 percent for the Euro area).
- UN population prospects project a shrinking labor force; rising dependency ratio could reduce output per capita and pressure public finances.
- Mission commends efforts to bring inactive people back into the labor force and supports further active labor market policy reforms and tackling constraints to economic immigration.
- Gender inequality:
- High gender pay gap of 25.2 percent in Estonia compared to 16.2 percent for the EU.
- 85 percent of the gender pay gap cannot be explained by available data.
- Recent measures: shortening maternity leave, increasing flexibility of parental benefit system, higher inclusion of fathers, possibility to partition parental benefits to three years.
- Mission supports increased pay transparency and increased availability/flexibility of childcare as promoted in the Gender Equality Act.
- Mission welcomes a research project aimed at improving gender payroll statistics and providing policy options.
- Corporate insolvency framework:
- Current insolvency procedures take around 3 years and the recovery rate is barely above 40 percent.
- The regime is far behind peers in efficiency and predictability, inhibiting capital reallocation.
- Mission welcomes efforts to examine the insolvency framework and recommends enhancements: allow creditors to initiate restructuring, provide options for out-of-court settlements, and develop an early warning system to detect signs of distress.
Financial Sector Policy
- Financial soundness indicators remain strong, but cross-border parent bank dominance is a vulnerability due to interlinkages and potential spillovers.
- Supervisory coordination:
- Staff welcomes efforts to shore up cross-border supervision including supervisory colleges with Scandinavian supervisors and greater transparency in cross-border banking activity since October 2018.
- Urges continued efforts to operationalize the memorandum of understanding signed with the Nordic-Baltic Stability Group and to enhance clarity in parent-home supervisory obligations.
- Luminor merger:
- The merger expanded banking sector size to 145 percent of GDP from 102 percent, increased concentration (three largest banks hold 85 percent market share), almost doubled the credit portfolio (accounting for branches in Latvia and Lithuania), and contributed to a one-off slight deterioration in consolidated asset quality (NPLs remain very low).
- Merger necessitates monitoring risks and considering developments in Latvia and Lithuania in macroprudential calibration.
- AML/CFT:
- Strengthening AML/CFT framework remains a priority.
- Mission welcomes implementation of AML/CFT risk-based supervision, regional cooperation, and domestic coordination among competent authorities.
- Legislative discussions ongoing to increase maximum fines for breaches and to reform and simplify the procedure for their application.
- Fund staff intends to incorporate an AML/CFT component into the Article IV consultation with the Republic of Estonia in 2019.
- Macro-financial vigilance and macroprudential stance:
- Staff supports keeping the countercyclical capital buffer (CCyB) at zero, owing to stable household debt, slow credit growth, and a forecast of moderating corporate debt due to weak investments.
- Mission concurs with authorities to introduce a risk weighted floor of 15 percent for housing loans to mitigate risks from high exposure.
- Staff will continue assessment of the macroprudential stance during the Article IV consultations.
Mission Contacts and Acknowledgements
- Mission led by Mr. Cheikh Gueye visited Tallinn during May 21 - 27, 2019 to establish contact with the new administration and prepare for the next Article IV Consultation mission expected in the fall.
- The mission team held discussions with: Prime Minister Jüri Ratas; Eesti Pank Governor Ardo Hansson and incoming Governor Madis Müller; Minister of Finance Martin Helme; members of the Finance and Budget Committee of parliament; and representatives of the financial sector.
- Mission expressed thanks to the Estonian authorities for their availability and cooperation.
IMF staff concluding statement, July 1, 2019.