Estonia: Staff Concluding Statement of IMF 2015 Article IV Mission
The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.
The Estonian economy is holding up well despite a difficult external environment. Economic and institutional fundamentals are strong, supported by a broad consensus in favor of market-oriented and disciplined policy making. Growth should pick up in the coming years, but making good headway in converging with Western European living standards will be a significant challenge. Closing the gap with Western Europe will require a strong focus on raising productivity growth. Many commendable polices are already in place or planned. These should be swiftly implemented and could be further strengthened. Fiscal policy can also play a supporting role.
Near-term Economic Outlook and Risks
1. Growth should reach 2 percent this year and strengthen to just under 3 percent in 2016. The main driver for GDP growth is private consumption on the back of buoyant real wage growth, while exports are hurting and investment remains subdued reflecting the weak external environment. Private consumption should remain strong and exports are set to become less of a drag as the economic difficulties in trading partners abate. Investment should also benefit from EU funds coming on stream under the Multiannual Financial Framework (MFF) 2014-20. Signs of tightness in the labor market suggest only limited slack in the economy despite moderate growth. The remaining negative output gap of less than ? percent of GDP should close by 2017. Inflation is projected at zero this year, reflecting import and energy price developments, along with administrative price cuts in higher education. Strong domestic wage growth, stabilizing global energy prices, and excise tax hikes should lift inflation to around 2 percent next year.
2. Risks to this outlook are mainly on the downside. Estonia is highly dependent on trade and its banking system is dominated by cross-border banking groups, meaning that its economic fortunes are closely tied to external developments. The projected growth pickup in trading partners is more likely to fall short than to exceed expectations. Volatility in global financial conditions could affect credit supply through the affiliates of foreign banks operating in Estonia. Domestic risks are more of a medium-term nature and relate to the outlook for potential growth and competitiveness.
Medium-term Prospects and Challenges
3. Maintaining strong economic growth is a challenge the world over, but the difficulty is more acute in Estonia, as well as in Central and Eastern Europe (CEE) generally. At the global level, economic growth is at risk of settling into a “new mediocre,” as investment drops off, productivity growth slows, and adverse demographics take their toll. In CEE, particularly challenging demographics and a slowdown in productivity growth that frequently occurs as middle-income levels are reached, compound these concerns.
4. The Estonian economy has made impressive strides, but growth and income convergence are slowing. Since the mid-1990s real annual GDP growth averaged some 4? percent—one of the highest rates in CEE. But a substantial income gap with Western Europe remains and the economy has expanded at a moderate rate of only 2 percent per year since mid-2012. Cyclical effects and difficult external conditions have played a role, but potential growth has likely also slowed. The mission projects it at some 3 percent over the next five years and somewhat below that for the longer run. This implies continued income convergence with Western European levels but at only about half of the historical pace.
5. Estonia’s medium-term growth outlook is underpinned by strong fundamentals. Chief among them are macroeconomic stability, impeccable public finances, a conducive business environment, high public investment, and effective government services. In addition, a host of promising initiatives are underway or planned. These include: (i) the work capacity reform aiming to bring people with partial disabilities back into the labor force; (ii) a revamping of enterprise support toward innovation and entrepreneurship, increasingly backed by financial instruments rather than grants; (iii) adoption of a life-long-learning strategy; (iv) an understanding to reduce public employment in line with the declining working-age population; and (v) further state reforms covering the central and local governments.
6. A stronger and clearer emphasis should be put on raising productivity as the central goal of economic policy to achieve the technological transformation needed to sustain convergence. In support, a strong unit in the Prime Minister’s office could be established with the explicit mandate to foster productivity growth. It would oversee the many initiatives at the ministerial level, keep track of government expenditure geared toward raising productivity, identify gaps, and assess programs’ effectiveness toward the goal of raising economy-wide productivity.
7. In the near term, the focus should be on getting existing plans off the ground. Since many programs are tied to EU funding under the 2014-20 MFF, they are still at the pre-implementation or piloting phase. Some of them could also be scaled up, such as active labor market policy measures, life-long-learning initiatives, and the strengthening of vocational training and apprenticeship programs.
8. In the medium term, existing programs could be supplemented. More emphasis could be put on the upgrading of traditional industries as a second leg of innovation policy. A reduction in the dependence on EU funds is not only imperative from a sustainability point of view, but would also give more flexibility in setting priorities and project design. In the area of labor market policy, a further increase in the statutory retirement age should be considered, flanked by training initiatives to ensure that the effective retirement age rises commensurately. Steps to further boost female labor force participation and more reliance on foreign labor also have economic appeal.
9. Estonia’s fiscal position is strong. Public debt is by far the smallest in the EU and more than fully covered by fiscal reserves. Second pillar pension funds have accumulated sizable assets. A fiscal surplus of 0.8 percent of GDP was recorded last year. Commendable improvements in tax administration have been achieved. The policy thrust of gradually reducing labor taxes and government employment in the years ahead goes in the right direction.
10. In the remainder of 2015, efforts should focus on executing budgeted investment. High government investment has been one of the hallmarks of Estonia’s fiscal policy. This has served the country well and—considering the still low capital stock compared with Western European economies—should be continued. The transition between financial frameworks for EU funds, which finance much of public investment, could lead to under-execution of investment that should be minimized, if needed by pre-financing “safe” projects. In the mission’s view, the fiscal surplus will likely decline to ? percent of GDP this year, due to labor tax cuts and increases in social benefit spending exceeding revenue gains from better tax administration and a “tax-friendly” composition of economic growth. This would usefully provide a moderate fiscal stimulus.
11. The 2016 draft budget provides for strong public investment, along with a budget-neutral combination of higher family benefits and excise taxes. While the budget will continue to post a surplus, the measures would entail a moderate fiscal stimulus because of added revenues from lumpy receipts, thus providing adequate insurance against downside risks in the growth forecast.
12. Longer-term, Estonia’s strict fiscal rule could be made more flexible to boost productive spending or accelerate labor tax cuts while preserving overall prudent fiscal policy. The current rule mandates at least structural balance. Uncertainties in budget execution and the calculation of structural balances prompt policy makers to aim for surpluses in practice. The rule is also asymmetric: deficits need to be made up by running surpluses in subsequent years, while surpluses cannot be spent later on. Moreover, it is debatable whether budget balance is even required when net public debt is already negative. Fiscal space may be better used to boost productivity-enhancing spending, front-load labor tax cuts, or compensate the eventual decline of EU funds.
External Developments and Competitiveness
13. Estonia’s external position is strong. The current account has been broadly in balance for the past five years. Gross external debt is rather high but net debt is negative and the negative net international investment position is fully covered by FDI. Despite weak exports, the current account is expected to be in a surplus position of about 2 percent of GDP this year on account of weaker investment.
14. Nevertheless, external price competitiveness will increasingly come under pressure if real wage growth continues at its current pace. Wage growth has significantly outstripped productivity growth in the last few years and company profits are declining. Export market shares, which have been rising for decades, are starting to flatten out. This underscores the need to achieve more productivity growth but also guard against excessive wage growth until it takes hold. In this context, the planned deceleration in central government wage growth is prudent. Care must be taken to ensure that the rapid minimum wage increase does not set the pace for general wage developments—annual increases of 10 percent for several consecutive years are unsustainable.
15. Indicators of financial soundness are exceptionally strong in Estonia, especially in the large foreign-owned institutions. The return to moderate credit growth since mid-2014 after many years of deleveraging is a positive development. The Bank of Estonia has put in place a strong macroprudential toolkit that also covers mortgage lending by foreign bank branches. Oversight of non-bank financial institutions is also being strengthened. The Bank Recovery and Resolution Directive has been transposed.
16. Estonia's financial sector is closely integrated with the Nordic-Baltic region. The cross-border banks that make up most of the financial sector are exposed to a range of risks, especially in property markets, although they also have strong lines of defense. Potential shocks in the region could spill over to Estonia in the form of tighter credit supply as well as through trade channels. It will therefore be important to remain vigilant and continue close cooperation with home-country authorities. In this context, regional cooperation in supervision and resolution should be reinvigorated, including through appropriate involvement of the ECB, which directly supervises the two largest Estonian banks.
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The IMF team is grateful for the generous hospitality of the Estonian authorities and would like to thank all interlocutors in government, the Bank of Estonia, the private sector, and in NGOs for constructive and fruitful discussions.