IMF Survey: 'Baltic Tiger' Plots Comeback
December 10, 2009
- Fiscal prudence during boom years protected Estonia from worst crisis fallout
- Growth expected to resume in mid-2010 but likely to be lower going forward
- Adopting euro in 2011 now within reach
Known as one of the three “Baltic tigers,” Estonia is now undergoing a severe recession.
But unlike some other countries in emerging Europe, this small country of 1.3 million has managed to escape a full-blown crisis, thanks in large measure to prudent policies during the boom years of 2004-07.
Even though Estonia is battling a 15 percent decline in output this year and a large rise in unemployment, its government is confident it can ride out the global economic crisis. So confident, in fact, that it has just announced it is close to meeting all the criteria set out in the European Union’s Maastricht Treaty for adopting the euro. The IMF cautiously concurs, noting in its recent assessment that “euro adoption in 2011 appears within reach.” The European Commission and the European Central Bank will issue their assessments around May and a decision could come from the EU’s Council of Finance Ministers in early summer 2010.
Euro adoption would represent a major milestone. But Estonia is not out of the woods yet. “The crisis left a legacy. The country now has a lot more private sector debt, and it has lost competitiveness,” says Christoph Rosenberg who, as mission chief, is responsible for coordinating the IMF’s policy advice to Estonia.
And of course, the crisis has led to a big decline in living standards, not least for those people who have either lost their jobs or have been forced to take a pay cut. “When I talk to people in Estonia, everybody agrees it was a tough year,” says Andres Sutt, until recently deputy governor of Estonia’s central bank. He now represents his country at the IMF as a senior advisor to the Executive Director for the Nordic-Baltic constituency.
As the economy rebalances, a quick rebound to the growth rates seen before the crisis is unlikely. The IMF is expecting the country to be capable of growth in the order of 3-4 percent a year, compared to 6-7 percent before the crisis. On the positive side, the high inflation of the boom years is unlikely to return.
Like many other countries in emerging Europe and around the world, Estonia was awash in foreign capital in the years that preceded the global financial crisis. Following the country’s entry into the European Union, foreign-owned banks moved in and started lending, often in foreign currency, to a public largely unaccustomed to credit. “The economy was fueled by easy access to credit, channeled through foreign-owned banks, and interest rates in real terms were very low, especially for first-time homebuyers and companies. Financing constraints were essentially removed,” explains Sutt.
"The economy was fueled by easy access to credit, channeled through foreign-owned banks."
The boom was driven by the belief that Estonia would soon join the ranks of advanced European countries. “EU and NATO membership was really a decisive moment, and gave the country a psychological boost. That explains why banks were willing to lend money to people, and people were willing to take loans, because they all felt: ‘very soon we are going to be at Finland’s income levels’,” says Rosenberg.
What happened next has become a well-known story: when Lehman Brothers collapsed in September 2008, international credit dried up, hurting those countries that had relied on easy foreign money. What set Estonia apart, however, was that the almost entirely Nordic-owned banks had already started to reign in lending well before the global crisis hit. “That controlled kind of slowdown or exit from the bubble could still have worked. But then, of course, came the global crisis,” says Rosenberg.
Fiscal house in order
Estonia was hurt badly by the crisis, mainly through a decline in foreign trade. But its public finances were not as exposed as many other countries’ to the drying up of global financial markets. This was because the country had accumulated sizable fiscal reserves during the boom years and had virtually no public debt going into the crisis. That proved to be a life saver, according to Rosenberg. “Estonia ran fiscal surpluses during the good years and built up a fiscal buffer. It did let down its guard a bit in the very last year of the boom by allowing expenditures to increase, but it was kept relatively under control, and the structural deficit was not as big as it could have been.”
The government also acted forcefully to address the budget deficit when the crisis first hit. “When the crisis fully hit after Lehman, the parliament was already looking at the 2009 budget, and in the last readings of the budget they adjusted spending because they had a sense of what was going to happen,” says Rosenberg.
Safeguarding the banks
Estonia’s financial system was also in better shape than in many other emerging market countries. For one thing, it has virtually no domestic-owned banks, which meant that the main banks operating in the country were fully backed by strong Nordic parents. For another, the central bank increased capital requirements and imposed reserve requirements amounting to 15 percent of all liabilities prior to the crisis, which meant the banks had sizeable buffers when the crisis hit. “When you don’t have domestic banks borrowing from international markets, you are in a much stronger position,” Sutt says.
During the boom years, wages and prices rose sharply. “There were wage increases in Estonia because of its strong and economy-wide links with Scandinavia. Proximity and easy commuting meant labor mobility was very high, so it lifted our wage level in a number of industries, particularly in construction services,” Sutt explains.
As a result, Estonia now needs to restore its competitiveness in international markets. With an exchange rate that has been fixed first to the deutsche mark and then to the euro for more than 15 years, this adjustment must take place in the labor and product markets. But Estonia has a highly flexible economy, and wages have already come down significantly, even in nominal terms. “Many observers just didn’t believe that the labor market could be this flexible,” Sutt says.
Another factor that helps is that Estonia’s labor market was in good shape prior to the crisis. “We entered into the crisis at an employment level of about 70 percent and very low unemployment of about four percent. So in that sense, it’s not surprising that there has been a very quick adjustment in the labor force,” Sutt explains.
"Succeeding with the euro will boost confidence and open up many new opportunities."
According to Rosenberg, Estonia may also have an advantage because it has a diversified production base with many small and medium-sized companies, including in high value-added sectors, such as information technology. Most famously, Skype was founded in Estonia and still maintains R&D operations there. Sutt concurs. “When I’m asked what Estonia is exporting, I say it’s a little bit of everything. An SME-based economy gives you a huge degree of flexibility.” He adds that Estonia’s future growth will depend on innovation in every sector of the economy, be it low- or high-tech.
A strategy for future stability
Since Estonia joined the European Union in May 2004, the goal of adopting the euro as soon as possible has been at the core of the country’s economic strategy. And now that goal is within tantalizingly close reach. Following recent budget measures, and assuming continued fiscal consolidation, Estonia could meet the Maastricht budget deficit criterion of 3 percent of GDP in 2009 and 2010—despite this year’s dramatic decline in GDP. The inflation criterion appears to have been met this month. “I don’t think we have ever been as close as we are today, but it’s not done until it’s done,” Sutt says.
“Fiscal policy has been strong, not only during the current downturn, but more importantly, during the good years, which shows that this is a country that has an inherent, strong sense of policy discipline,” Rosenberg says. He nevertheless recommends that the authorities take measures on top of the recently agreed 2010 budget to make sure that the Maastricht criterion is met in a sustainable fashion. “Slacking off at the finish line would be an unforgivable mistake.”
Looking to the future
So is there a feeling that the worst is over? According to Sutt, now that the economy has most likely bottomed out, confidence is gradually returning. “In the spring, there were very depressed expectations for autumn. Well, autumn has arrived, and it turned out not to be as bad as many feared. Succeeding with the euro will boost confidence and open up many new opportunities.”