Public Information Notice No. 04/126

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Republic of Estonia

November 11, 2004

On November 8, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Estonia.¹

Background

Estonia's successful economic performance over the last decade culminated in EU accession on May 1, 2004. Estonia joined ERM II, maintaining its currency board at the preexisting peg against the euro. The country has been among the fastest growing of the accession countries: per capita GDP has almost doubled since 1993 and reached around 45 percent of the EU average in 2003 in Purchasing Power Parity terms. However, the external current account deficit deteriorated sharply since 2002 and remains high.

Economic activity has been gathering speed. Year-on-year growth accelerated to 6.8 percent in 2004Q1 from 5.8 percent in 2003Q1, driven by domestic demand and supported by technology sector exports. Inflation accelerated in the first half of 2004 as a result of EU tax harmonization. But no lasting rise in inflationary pressures is foreseen. Unit labor costs increased only modestly, with productivity gains dampening the effect on the growth of real wages.

The external current account deficit widened to 13.2 percent of GDP in 2003. Although it is expected to decline, as part of the deterioration was due to "one-off" investments of about 5 percentage points of GDP related largely to energy and transportation, the underlying current account deficit was higher than its historical average. However, the high current account deficit does not appear attributable to worsening competitiveness—market shares of Estonian exports to the main trading partners increased.

Fiscal policy tightened in 2003: the general government surplus more than doubled to 2.4 percent of GDP. This has occurred in part because of strong revenue performance stemming from stronger-than-expected domestic demand and employment growth. Some of the fiscal tightening, however, resulted from postponed personnel and administrative expenditures and will be reversed in 2004.

Domestic credit growth remained high and was financed mainly by banks' external borrowing from foreign parent banks. Year-on-year credit growth to households accelerated to around 50 percent at the end of the first half of 2004, as households borrowed to acquire real estate. However real estate prices rose only modestly in 2003 and remained stable in the first half of 2004.

Estonia's banking system remains financially sound. The percentage of non-performing loans declined further and, at 0.4 percent of the total, is the lowest among transition countries. Although bank competition and declining interest rates squeezed margins and interest income declined, bank profits remained strong, with income from services fees growing briskly and Estonian banks expanding in neighboring markets.

Executive Board Assessment

Executive Directors welcomed Estonia's accession to the European Union and early entry in ERM II. This followed solid economic performance during the past decade, and a successful transition to a market economy underpinned by prudent fiscal policy, along with flexible labor and product markets. Directors commended the authorities for Estonia's remarkable nominal and real convergence with the EU, and agreed that the economy is well placed to meet the challenges of adopting the euro. They also welcomed the exemplary track record of cooperation between the Fund and the Estonian authorities.

Directors noted that Estonia's high and rising external current account deficit is partly explained by one-off factors, and that a large part of the deficit has been financed by foreign direct investment inflows. Furthermore, Estonia's external competitiveness remains strong. Nevertheless, most Directors agreed with the view that the continuing high current account deficits are a potential cause of concern and may not be sustainable over the medium term.

Looking ahead, Directors underlined the importance of maintaining a prudent fiscal policy stance in order to avoid exacerbating the current account imbalance and to minimize the risks under ERM II in the context of the currency board arrangement, which has served Estonia well. The currency board arrangement remains credible, as indicated by Estonia's relatively high credit rating, and is a viable strategy in the run-up to euro adoption. Directors underscored that macroeconomic and structural policies will need to continue to be carefully directed at underpinning this credibility, with fiscal policy playing the dominant role in restraining domestic demand and curbing inflationary pressures.

Against this background, Directors called on the authorities to maintain in 2005 a fiscal surplus similar to that expected in 2004. Furthermore, over the medium term, the surplus should decrease only gradually until fiscal balance is achieved. This will be necessary in order to avoid a large and unwelcome fiscal stimulus. Directors considered that such an approach will help to avoid overheating the economy, restore the current account balance to more sustainable levels, and reduce external vulnerabilities.

Directors cautioned the authorities that the planned income tax cuts over 2005-07 will require identifying offsetting savings. Given the primacy of the objective of fiscal restraint, taxes should be reduced only if realistic expenditure cuts, or other revenue sources, have been clearly identified. Further rationalization of the large number of local governments and improvements in intergovernmental finances should provide some relief to the budget and help accommodate the tax cuts and enhance public sector efficiency.

Directors observed that labor market flexibility, and wage increases that are in line with improvements in productivity, will also remain vital for maintaining external competitiveness and supporting the currency board. Moderation in public sector wage growth will be of crucial importance in light of its signaling effect on the private sector. Directors welcomed the authorities' intention to focus efforts on drawing unemployed youth and the long-term unemployed into the labor market through the use of active labor market policies, including better-targeted vocational training to reduce skill mismatches and reform of the unemployment benefits scheme.

Directors commended the successful pension reform in Estonia. Going forward, a key challenge will be to address the needs of an aging population and increasing health care spending while ensuring long-term fiscal sustainability. Directors underscored that the fiscal surpluses required currently for macro stability also represent an opportunity to make appropriate provision for the future needs of Estonian citizens. The recent adoption of multi-year budgeting is a welcome step in achieving this goal.

Directors noted that the banking sector remains well-managed and sound, with adequate capital and low non-performing loan ratios. However, they cautioned that the recent rapid credit growth could pose a risk to macroeconomic and financial stability, and should continue to be monitored carefully. Directors welcomed the authorities' recognition of the need for conservative lending practices, supported the planned reduction in mortgage interest deductibility to limit credit growth, and recommended that consideration be given to tightening prudential controls if needed. Directors also welcomed Estonia's implementation of legislation to combat money laundering and terrorism financing.

Directors commended the completion of most large-scale privatizations and the progress made in restructuring and liberalizing the energy sector.