Estonia -- 2004 Article IV Consultation, IMF Concluding Statement
June 18, 2004
An IMF mission visited Tallinn from June 7th to June 18th to discuss recent economic developments in Estonia with the authorities and the government's economic policy agenda for the remainder of 2004 as well as 2005 and beyond. This year's consultation took place shortly after Estonia's accession to the EU and focused on policies appropriate to support a smooth adoption of the euro. As in the past, the discussions were very productive and extremely cordial.
Estonia's remarkable economic transition and solid economic performance culminated in EU membership on May 1, 2004. The country has already made a good deal of progress in meeting the Maastricht criteria, with all convergence indicators—the fiscal balance and pubic debt, in particular—at levels better than those in the other new EU members. The authorities intend to enter the ERM II in a timely fashion, unilaterally maintaining the currency board arrangement, and subsequently adopt the euro. While, in our opinion, this strategy is viable and the timetable appears feasible, it is not without risks. Credible and prudent macroeconomic and structural policies will be important in the period ahead to make certain that the Estonian economy remains competitive, to ensure a smooth entry into the ERM II and, ultimately, to successfully adopt the euro. Estonia has an enviable record in implementing sound policies that have supported strong growth and a stable price level. We commend the authorities for this and we urge them to continue on this path and not become complacent.
Overall macro developments remain favorable. Strong economic growth continues, despite a delayed recovery of demand in Estonia's major trading partners, driven by robust investment and private consumption. The negative contribution of net exports to growth has declined, reflecting increased foreign demand in the second half of 2003. The current account widened somewhat—primarily due to several one-off transactions—and remains a concern. Inflation increased in mid-2004, driven by one-off increases of fuel, sugar, and tobacco prices largely as a result of EU tax harmonization. Economy wide, real wages increased substantially in 2003, but productivity gains dampened the effect on real unit labor costs, which increased only modestly. Fiscal performance was strong, with the general government surplus of 2.4 percent of GDP, and contributed importantly to maintaining macroeconomic stability.
Looking ahead, external conditions are expected to improve over the medium term and the outlook is favorable if appropriately tight policies continue to be followed. In 2004, real GDP is projected to grow by 5½ percent, driven by strong domestic demand and the anticipated pick up in exports to Europe. Average inflation is forecast to be about 3 percent, as a result of EU tax harmonization and an increase in administered prices. Over the medium term, we project real GDP growth to be on the order of 5 percent, supported by a vigorous increase in productivity and strong external demand. Average inflation is envisioned to remain within the Maastricht criteria, but uncertainty about possible oil price increases and the impact of rising income levels on prices suggest that the risks are on the upside.
However, the current account deficit remains high and continues to be a cause of concern. Not because it signals a loss in competitiveness—conventional measures of competitiveness indicate that this is not a problem in Estonia—but because it indicates growing tensions that are not sustainable over the medium term if left unaddressed. Because Estonia has a currency board arrangement, the instruments available to reduce these tensions and imbalances are largely limited to fiscal policy. Unlike countries that have a floating exchange rate regime, interest rate and exchange rate changes are not viable options.
Thus, we recommend that the authorities continue to pursue the tight fiscal policies of 2003 in 2004. One reason for this is to restore the current account to a level that can more easily be sustained over the medium term. A second reason for a fiscal surplus in present circumstances is to adequately provision for the future needs of an aging population by saving government revenues today for use tomorrow. The recent adoption of a multi-year budgeting program is a welcome step in this direction and we commend the authorities for it.
There are some uncertainties ahead that may put unexpected strains on the public finances and the authorities must be prepared to act if an aging population coupled with increasing health care costs, put pressure on the budget. Accordingly, in our view, the supplementary budget should place all of the 2003 surplus in a fund to be used to finance the future needs of the first pillar of the pension program and target a fiscal surplus in 2004 of the same magnitude as that achieved in 2003. Doing this, together with favorable external demand and increase in private sector saving, should lead to a current account deficit of about 6 percent of GDP in the medium term, avoid over stimulating the economy, and help provide for the future needs of Estonians.
We endorse the authorities' plans to reduce income taxes over 2005−2007. However, the government's objective of fiscal balance must have primacy and taxes should only be reduced if realistic expenditure cuts (or other revenue sources) have been clearly identified. Further rationalizing the large number of local government units would, in our view, provide some relief to the budget that would help accommodate the tax decrease and, also, improve efficiency in the public sector. The mission also took note this year of some difficulties in the financial relations between the central and local governments and stands ready to provide technical assistance if the authorities think it useful.
Last year the mission noted of the recent practice of off-budget financial operations, such as the planned increase of the capital of the public real estate company, which, while legal, could undermine Estonia's hard earned reputation for transparency of fiscal policy. We continue to caution against this at all levels of government.
In addition to prudent fiscal budgeting, the need for a flexible labor market remains paramount in supporting the currency board. External competitiveness will be maintained only if wage increases reflect, over the medium term, improvements in productivity. While most wage agreements are conducted at the firm level, taking into account specific developments, the government must remain aware of the signaling role that it provides in determining public sector wages. The mission also welcomes the authorities' intention to focus efforts on integrating youth and the long-term unemployed into the ranks of wage earners through the use of active labor market policies.
The mission supports the authorities' plan for an early entry into the ERM II while unilaterally maintaining the currency board regime. The currency board has served Estonia well, but only because it has been accompanied by tight fiscal policy. And tight fiscal policy, for the reasons outlined above, remains the key to the success of this strategy.
Credit growth in Estonia has been very strong recently. Some of this is normal and is to be expected as the financial system grows to EU norms, but some of it likely reflects a nascent overheating. Given the constraints of a currency board arrangement, the Bank of Estonia's ability to react to this is limited. However, we do support their actions to curtail the strong growth in credit through measures such as moral suasion. And we do recommend that the authorities continue to closely monitor credit growth and stand ready to take appropriate actions as necessary to ensure the continued health and stability of the banking system. In this regard, we support the authorities' plan to further reduce mortgage interest deductibility and recommend that they carefully assess the macro implications of any future increases in either the overall or individual legal limits on Kredex to guarantee mortgage debt.
We commend the authorities for implementing policies that have led to the successful transformation of the Estonian economy into a market economy that is enjoying strong growth and stable prices, and led, ultimately, to EU accession. But full integration into the euro area is not yet complete and we urge the authorities to guard against complacency and to continue with prudent policies.