February 11, 2000

Dear Mr. Camdessus:

The attached Memorandum of Economic Policies describes the policies the Government and the Bank of Estonia intend to follow in 2000 and in the first half of 2001. The currency board arrangement is a corner stone to our policies and fully consistent with providing a strong foundation for rapid and sustained economic growth through maintaining macroeconomic stability and increasing the efficiency and competitiveness of the Estonian economy. We will reduce the budget deficit, and initiate a number of key long-term reforms, including in public finances and administration, the pension system, and the financial sector as well as further restructuring and privatization of the few large infrastructure companies still in state hands. This economic reform program will also be an integral part of our EU accession strategy. In support of these policies, we are requesting a stand-by arrangement in the amount of SDR 29.34 million for the period until September 2001. Our balance of payments has strengthened substantially in 1999 despite an adverse external environment, and we do not anticipate that a need for any purchases under the arrangement will arise.

We believe that the policies described in the attached memorandum are adequate to achieve the objectives of our economic program, but we will take additional measures to meet these goals should the need arise. During the period of the arrangement, we will consult with the Fund on the adoption of any such measures that may be appropriate in accordance with the Fund's policies on such consultations. Further, we will conduct with the Fund two reviews of economic developments and policies under the program, the first by end-June 2000, and the second by mid-December 2000. In addition to a comprehensive evaluation of economic performance under the program, the first review will focus particularly on the evolution of Estonia's fiscal position, and the pace of economic recovery and its impact on the balance of payments. The second review will focus on the budget for 2001. The program will also be evaluated on the basis of a number of quarterly quantitative as well as one structural performance criteria, and structural benchmarks (enumerated in the attached annexes to the Memorandum of Economic Policies). Performance criteria for end-March 2001 and end-June 2001 will be specified at the time of the second review.

Attachments

I.  Recent Economic Developments

1.  Economic developments in the second half of 1998 and for much of 1999 were dominated by fallout from the Russia crisis that broke in August 1998. The overheating of the economy in 1997, banks' exposure to the stock market and an asset price bubble, and excessive credit growth fueled by easy access to foreign financing, had left the Estonian economy, and particularly the banking system, vulnerable to shocks. Contagion from Asia and the stock market reversal in late 1997, the unexpected and sharp contraction of eastern export markets, and further disturbances in international capital markets triggered by events in the CIS imposed a heavy burden of adjustment on most sectors and regions, especially those that relied heavily on the Russian market (notably the agricultural sector). While the impact of events in late-1997 on the Estonian banking system and internal capital markets was short lived, it contributed to an acceleration of the restructuring of the banking system and a pronounced slowdown in bank lending. The latter reflected also a more cautious assessment by banks of the risk of lending to firms with exposure to CIS markets. In combination, these elements reinforced the slowdown in economic activity. After peaking at nearly 11 percent in 1997, real GDP growth declined to 4 percent in 1998, and real GDP is estimated to have fallen in 1999 by about 1 percent.

2.  The pronounced weakening of economic activity in 1998, which was accompanied by an unexpectedly rapid decline in the rate of inflation, also served to invalidate the fiscal and financial program targets under the economic program of the government and the Bank of Estonia for 1997-1998 as outlined in the Memorandum of Economic Policies (MEP) of November 7, 1997. ¹

3.  The early reorientation of exports from Russia and other CIS countries toward Western and Central European markets has helped to limit the impact of the Russia crisis. While the agricultural sector has been severely affected by the downturn in Russia, export-oriented manufacturing has continued to do well, taking advantage of Estonia's low-cost business environment and its skilled labor force. In combination with a weakening of import demand on account of the economic downturn, this resulted in the current account deficit declining from a peak of 12 percent of GDP in 1997, to 9 percent of GDP in 1998, and an estimated 4 percent of GDP in 1999.

4.  After a budget surplus equivalent to 2 percent of GDP in 1997, the general government registered a deficit of 0.3 percent of GDP in 1998 (EEK 0.2 billion) as a result of the impact of the economic slowdown on revenue collection and slippages on the expenditure side toward the end of the year. The general government fiscal position deteriorated further in early 1999 as continued weak revenue growth coincided with substantial increases in public sector wages and pensions. In addition to the weaker economy, a number of one time factors also contributed to a pronounced contraction of revenues in the first quarter of 1999 (faster VAT rebates, changes in the due dates for the payment of social insurance taxes, and the reorganization of the social tax collection system). However, the influence of these factors had faded by mid-year. To reverse the widening of the budget deficit, the government introduced a supplementary budget in June 1999 that reduced authorized spending in the second half of 1999 by about 1.3 percent of annual GDP (or EEK 1 billion). Together with additional expenditure restraint, the budget deficit in the second half of 1999 was kept to 3.0 percent of GDP and the deficit for the year to 4.8 percent of GDP. The deficit was largely financed through the use of the proceeds from the partial further privatization of Eesti Telekom in early 1999.

5.  The practice of holding part of the government's cash balances abroad began in late 1997. The original objective was to sterilize the impact of the fiscal surpluses and privatization proceeds. Initially these balances represented the counterpart of fiscal surpluses accumulated in 1997 and early 1998, but these were later augmented by the transfer of about half of the privatization proceeds from the Eesti Telekom sale in early 1999. These resources are managed by the Ministry of Finance consistent with guidelines agreed with the Bank of Estonia that limit investments to assets of the highest quality. After the inflows associated with the Eesti Telekom receipts, the balances in the government accounts held abroad rose to EEK 2.8 billion in mid-1999, but then fell to EEK 2 billion (or 2.7 percent of GDP) at year-end, reflecting the use of these resources to finance the fiscal deficit in the second half of 1999.

6.  Included in government deposits held abroad are the assets of the Stabilization Reserve Fund (SRF). The SRF was established mainly as a contingency reserve in case of macroeconomic emergencies. Legislation that became effective on January 1, 2000 further articulated the sources and uses of funds held in the SRF. It provided for the transfer into the SRF of, inter alia, all surpluses of the state budget, selected privatization receipts, and other one-off revenues (including dedicated transfers from the state budget). In addition, profit transfers from the Bank of Estonia may also be added to the SRF. The operations of the SRF are overseen by its Board which includes, inter alia, the Minister of Finance and the Governor of the Bank of Estonia. In the absence of exceptional and unexpected financing needs, the government foresees that the bulk of SRF resources would be used to finance the pension reform. The use of SRF resources for any purpose will require approval by parliament. In the period ahead, we are committed to add all further proceeds from the privatization of the remainder of Eesti Telekom to the SRF and to keep all SRF resources in accounts abroad.

7.  Monetary and credit developments during late 1998 and 1999 reflected primarily the deterioration in the international financial environment following the Russia crisis, the subsequent slowdown in economic activity in Estonia, and the restructuring of the banking system. Weak demand for credit, combined with more cautious bank lending policies as a result of increased risk perception because of the economic downturn, has kept total credit to the private sector broadly unchanged in the year through mid-1999 after which some modest increase in lending was experienced. There has been a rebound in broad money growth since mid-1999, reflecting increased financial savings by households; part of this rebound served to offset the monetary contraction experienced in the second half of 1998. While there had been a pronounced increase in interest rates after the onset of the Russian crisis in August 1998, nominal interest rates began a steady decline late in 1998 and are now at historic lows.

8.  During 1998, the banking system suffered the delayed consequences of excessive risk taking and weak management practices during the boom period of 1996-97. A number of banks, especially the smaller ones, experienced difficulties in dealing with the unexpected deterioration in the international financial environment and the weakening of their loan portfolio as a result of the impact of the contraction of Eastern export markets and the economic slowdown on their clients. As a result, in the period June-December 1998 a total of four banks failed (representing 14 percent of total bank assets at end-March 1998). Maapank, EVEA, and ERA Bank were declared bankrupt, while Forekspank was taken over by the Bank of Estonia and merged with the Estonian Investment Bank to form Optivabank. These adverse developments, however, were outweighed by two large mergers and the acquisition of strategic equity stakes by foreign investors in the two largest Estonian banks (Hansapank and Uhispank--with a combined share in total bank assets of 85 percent--that together materially strengthened the financial system. By end-1999 only six banks (including one new bank that was granted a license in September 1999)--plus one foreign branch--remained in operation in Estonia. We view this process of bank consolidation as healthy and a normal consequence of an accelerated transition to a market economy.

9.  Since late 1997, the Bank of Estonia has been implementing a major long-term program of strengthening prudential regulations and improving banking supervision with technical assistance by the IMF. To address concerns regarding bank stability following a period of rapid credit expansion in 1997, late that year the Bank raised the capital adequacy ratio to 10 percent and the reserve requirement to 13 percent. These ratios have been kept at these relatively high levels despite the consolidation in the banking system mainly to ensure that confidence in Estonian banks remains unshaken. Prudential oversight was also strengthened through, inter alia, the inclusion of bank guarantees in the basis for the calculation of the capital adequacy ratio, the introduction of new limits on net open foreign exchange positions, and the application of prudential regulations on a consolidated basis for bank groups. As a result, Estonia's existing legal and institutional framework is consistent with full compliance with the Basle Core Principles on Bank Supervision. In addition, the Deposit Insurance Fund became effective in October 1998, the new Credit Institutions Law became effective in July 1999, and as of July 1, 1999, the Bank of Estonia has started to remunerate all commercial bank reserves at the European Central Bank deposit rate. Together these measures can be expected to contribute to creating a stronger and healthier regulatory environment.

10.  With basic structural reforms completed for some time, the government's attention is now focused on the more complex and difficult second generation reforms. The process of restructuring and privatization of Eesti Energia (the electricity generation complex) continued with (i) the conversion of Eesti Polevkivi (oil shale mining) in April 1996 into a joint stock company and (ii) the establishment of a joint stock company (Narva Power Stations) in November 1999 combining the two major power stations (with a majority interest in Eesti Polevkivi to be added in the first half of 2000). The privatization of other state enterprises, including Estonian Railways and the alcohol producers (Liviko and Moe), was either completed or well advanced. A further 24 percent of Eesti Telekom was privatized in February 1999, leaving only 27 percent of shares in the hands of the government. Land reform is advancing with the restitution of land proceeding about as scheduled. In addition, amendments to the Competition Law became effective in October 1998 improving compliance with EU requirements, health reforms are well underway, and there has been substantial progress on pension reforms. (Reforms in these areas are described in more detail below.) Moreover, Estonia subscribed to the IMF's Special Data Dissemination Standard (SDDS) in September 1998.

II.  Objectives and Strategy for 2000-2001

11.  We have experienced the first significant cyclical slowdown since the beginning of Estonia's transition to a market economy largely on account of the Russia crisis and related events in CIS countries. However, CIS markets appear to be stabilizing and are even showing signs of recovery, while Estonia's main export markets in the EU are expected to grow relatively strongly in the period ahead. Moreover, disturbances in international capital markets have subsided. Against this favorable background, the main challenge during the program period will be to strengthen the fiscal position and to give new impetus to structural reforms. This will lay a good basis for economic recovery and sustained economic growth.

12.  In these circumstances, the joint objectives of the government and the Bank of Estonia for 2000-2001 are to provide a strong foundation for rapid and sustained growth through: (i) maintaining external and macroeconomic stability and (ii) increasing the efficiency and competitiveness of the Estonian economy. To that end we will push ahead with a number of key long-term reforms, notably in public finances and administration, the pension system, and the financial sector as well as with further restructuring and privatization of the few remaining large infrastructure companies where state participation is still dominant. Over the medium-term, these measures should materially strengthen the working of market forces, improve resource allocation, and provide an important boost to private sector confidence.

13.  This economic and reform program will also be an integral part of our EU accession strategy. The main goal of this strategy is to consolidate the substantial progress already made toward meeting the "Copenhagen criteria" for EU membership, particularly by maintaining a fully-functioning market economy and strengthening Estonia's capacity to cope with competitive pressures and market forces within the EU.

14.  Our economic objectives will be pursued in the context of our long-standing currency board arrangement, which continues to provide a stable, transparent, and consistent policy framework. As demonstrated by the sharp improvement in our current account position and solid export growth to western markets, the current exchange rate peg remains appropriate. We intend to maintain the current fixed relationship between the kroon and the DM and euro until Estonia becomes a full participant in the EMU, at which point the euro will become Estonia's currency.

15.  The main macroeconomic parameters and targets underlying our program for 2000 are as follows:

• Following the decline in output experienced in the first half of 1999 and the modest recovery experienced in the second half, we anticipate that economic activity will further strengthen in 2000. With CIS markets no longer in decline, we project the return to positive economic growth to result primarily from the continued growth of exports to western markets, supported by an initially moderate recovery in domestic investment and consumption demand. With the banking difficulties now overcome, a flexible labor market, the exit of weaker enterprises, price stability, growing integration with Scandinavian and other Western markets, and the successful completion of first generation structural reforms, we believe that the Estonian economy is well positioned for a renewed take-off of economic growth. Accordingly, we estimate that growth will accelerate to about 4 percent in 2000. From 2001 onward, we expect growth to reach 5-6 percent per annum, which we believe is a rate of growth that can be readily sustained over the medium-term.

• While in a small open economy with a fixed exchange rate, inflation cannot be targeted, we project that CPI inflation will be about 4 percent in 2000 (on average). Accordingly, we project an increase in nominal GDP in 2000 of about 8 percent.

• Although competitiveness remains intact, and is expected to remain so over the medium term, a moderate widening of the current account deficit to about 5½ percent of GDP is expected for 2000 due to the quickening pace of recovery in domestic demand. However, we project that as a result of the prudent approach to fiscal policy described below, robust private savings, and fast export growth, the current account deficit will remain at sustainable levels over the medium term. We also expect that it will continue to be financed primarily by non-debt creating flows.

• As in 1998, FDI and portfolio investment inflows comfortably exceeded the current account deficit in 1999--in large part due to the privatization of Eesti Telekom early in the year. With substantial balances in government deposits held abroad and a strong improvement in the net foreign asset position of the banking system, we estimate that Estonia's net indebtedness was substantially reduced in 1999. We are confident that as the EU accession process advances, Estonia will continue to attract considerable capital inflows, including foreign direct investment. We note that Estonia has retained its investment grade credit ratings despite the turbulence in international markets late in 1998.

16.  The fixed exchange rate and currency board leave fiscal policy as the only direct instrument for aggregate demand management. With signs of an onset of a moderate recovery and the current account deficit at a level that can very likely be sustained over the medium-term without significant increases in external debt, we believe that there is not a strong case for setting budgetary policies from a short-term perspective either to stimulate the economy or to restrain aggregate demand and the current account deficit. Instead, the primary objective of fiscal policy in the present economic circumstances should be to promote the medium-term sustainability of quality growth while safeguarding the progress already made in reducing the external current account imbalance. In our view, this objective would be well served by aiming at a budget, which, on average, is balanced over the medium term, while at the same time providing for a gradual decline in the tax burden from 2001 onwards. This approach would also be consistent with the harmonization of fiscal policy with EU requirements under the Growth and Stability Pact.

17.  Estonia has made rapid progress in the implementation of structural reforms. Sustained structural reform effort will, however, be required to further improve productivity and maintain export competitiveness, boost the supply response of the economy, encourage domestic savings, and continue to attract foreign direct investment. Two key priorities in this regard are the pension reform program and the privatization of the energy complex. In addition, we intend to (i) make more transparent the structure of our public finances, inter alia, by consolidating into the state budget the utilization of foreign loans and grants, (ii) start the reform of public administration, including by increasing the transparency of public employment and remuneration, (iii) strengthen financial sector regulation and move cautiously toward consolidating financial sector supervision under one independent authority, and (iv) continue the reform of the public health care system.

III.  Policies

Policy design and coordination

18.  In the context of its EU accession program, the government approved Estonia's Medium-Term Economic Program (MTEP) for the period 1999-2003 in November 1999. The MTEP establishes broad quantitative macroeconomic priorities over its program period and outlines key structural reforms in the medium term. The policy framework set out in the MTEP is fully consistent with the policies set out in this Memorandum. The government and the EU Commission will conduct annual joint assessments of developments under the MTEP.

19.  An essential element in the formulation of medium-term economic and reform policy is the harmonization of the fiscal policy framework with EU requirements, which, inter alia, call for Estonia's adherence to the Growth and Stability Pact, including taking effective action on receiving information indicating the risk of an excessive deficit (greater than 3 percent of GDP). Certain provisions in the new Basic Budget Law (see paragraph 28 below) will already go a long way toward meeting this goal. Notably, Estonia is already participating in a pilot project with the EU Commission and EUROSTAT, aimed at training and familiarizing officials from accession countries with policy making and control at the EU Commission level.

20.  The government and the Bank of Estonia will by June 30, 2000 initiate an assessment of the extent of Estonia's compliance with the Code of Good Practices in Fiscal Policy and the Code of Good Practices on Transparency in Monetary and Financial Policies. Based on the conclusion of these assessments, an action plan will be formulated to bring the principles of policy making and reporting in full compliance with both codes. If necessary, technical assistance from the IMF will be sought to that end. In addition, Estonia has agreed to participate in the joint World Bank-IMF Financial Sector Assessment Program (FSAP) to help identify strengths and weaknesses in its financial system; preliminary work in this area is expected to get underway in February 2000.

Fiscal policy and public finance reform

21.  The budget for 1999 had been formulated in mid-1998, during the run-up to the national elections, on the expectation of continued fast real and nominal growth of the economy. As noted earlier, however, the adverse external conditions facing the economy precipitated a significant contraction in economic activity beginning in the second half of 1998 and continuing through the first half of 1999. Together with the substantial increases in wages and pensions awarded under the 1999 budget, and also the negative impact on revenues (estimated at 1 percent of GDP) of the one-time factors noted in paragraph 4 above, this contributed to a marked widening of the public sector deficit to 8.6 percent of GDP in the first quarter of the year.

22.  The new government coalition that was formed after the March 1999 national elections immediately took action to contain the fiscal deficit to 5 percent of GDP in the second quarter. It also cut expenditures in the second half of 1999 through a supplementary budget, and by deferring to 2000 about EEK 440 million of expenditures.

23.  The budget for 2000, which was adopted by parliament on December 15, 1999, originally had two main objectives (i) to achieve fiscal balance; and (ii) to reverse the trend of a sharply increasing share of government in the economy. (Government expenditures reached nearly 44 percent of GDP in 1999, up from about 38 percent of GDP in 1997.) To that end, the 2000 budget provides for no general increase in nominal wages and pensions (following a 20 percent increase in real terms in 1999). Including deferred expenditures, spending on goods and services and transfers to households will show a moderate increase in real terms, whereas investment spending will be reduced somewhat in real terms (as it will be kept constant in nominal terms relative to the 1999 level). However, in accordance with our preparation for joining NATO, we increased defense outlays from about 1.2 percent of GDP in 1999 to about 1.6 percent of GDP in 2000. Taking into account the impact of deferred expenditures, total expenditures in 2000 will be less than 4 percent higher in nominal terms than the 1999 outcome, although expenditures in 2000 include self-financed outlays of government agencies.

24.  With regard to revenue, the budget for 2000 incorporates a number of important tax policy measures. Effective January 1, 2000, we have taken the following measures:

• the corporate income tax on retained profits was eliminated. This, we believe, will remove the inefficiencies stemming from the double taxation of profits and will provide an important boost to investments. At the same time, employee fringe benefits, including company cars, became subject to income taxation;

• the amount of personal income exempted from income tax was increased from EEK 500 per month to EEK 800 per month;

• agricultural import tariffs were introduced at, or below, WTO bindings (which are below prevailing EU tariff levels). While the revenue impact of this measure will be small, this step is intended mainly to ensure that a well functioning border control mechanism is established and that Estonia will, in due course, be able to handle the administration of the complex EU trade regime;

• the excise rate for tobacco and tobacco products was raised by about 10 percent;

• VAT rebates for exports can no longer be claimed for goods stored in customs warehouses, but only for goods physically leaving Estonia.

In addition, excise rates for fuels were raised on average by about 25 percent effective December 1, 1999. We will also take the following measures during 2000:

• the approved budget is based on the nonrenewal of the zero VAT ratings (when they expire in June 2000) for thermal energy, peat, briquettes, coal, and firewood sold to households. These zero ratings, which are inconsistent with EU guidelines, had previously been extended annually;

• we will establish excise warehouses for alcohol, consistent with EU guidelines by July 1, 2000. This measure is expected to improve the administration of excises on alcohol and bring additional revenue to the budget;

• we will introduce excise taxes on fuel components by July 1, 2000.

We project that the above tax policy and administration measures will generate additional revenue in 2000 in the order of about EEK 1.9 billion (about 2.4 percent of GDP). This additional revenue will broadly offset the revenue loss from the abolition of the corporate profit tax and from the increase in the minimum personal income exempted from income tax, which together is estimated to amount to about EEK 1.8 billion.

25.  While parliament has passed a formally balanced budget for 2000, the deferral of expenditure from 1999 to 2000 makes the goal of a balanced budget no longer attainable. Moreover, the budget excludes foreign financed investments and net lending of about EEK 310 million. In addition, we recognize that there is a considerable downside risk associated with our revenue projections for 2000. Specifically, it is difficult to estimate precisely the additional revenue that will be generated from the tax policy and administration measures outlined in the paragraph above. We are, however, firmly committed to keeping the fiscal deficit of the general government in 2000 to no more than 1.25 percent of GDP. To that end, we will monitor closely fiscal developments, in particular by establishing monthly expenditure targets, to ensure that the fiscal deficit path during the course of the year remains consistent with our target for the year as a whole. We also stand ready to take additional measures, if necessary, to contain the fiscal deficit. These measures could include (i) extending to the whole country the car tax that currently applies to Tallinn; (ii) introducing an excise tax on heavy heating fuels; and (iii) cutting end-year bonuses for public sector employees. Finally, in the event of unexpected developments leading to a significant widening of the fiscal deficit, the government will be prepared to submit to parliament a supplementary budget with corrective measures. In contrast, any excess in budget revenues over projected amounts will be used to reduce the general government fiscal deficit further.

26.  With regard to 2001, we are aiming at a balanced budget, excluding any impact of further pension reforms. We intend to reduce general government expenditures (as a ratio to GDP) further by keeping the general government outlays constant in real terms. Over the medium term, we aim at broad budget balance, including the impact of the pension reform.

27.  In the coming years, public expenditure priorities will be affected by a number of factors. First, the need to maintain a sufficient social safety net for vulnerable groups, e.g., pensioners, large families, the unemployed, and population located in less developed regions, will necessitate continued significant outlays. The pension increases given in 1999 have done much to strengthen the income of the retirees. In the long run, pension reform (described below) will contribute significantly to the welfare of the elderly. Second, preparation for EU accession will place an increasing burden on certain areas of public spending in the next few years, particularly transportation, energy, and the environment. The need for this spending is dictated by our primary strategic goal of joining the EU as quickly as possible. While these outlays will tend to widen the budget and current account deficits, we also expect to receive substantial financial support, much of it in the form of grants, in preparation for EU membership. Our foreign policy objective of integrating Estonia into NATO will also require some further increase in defense spending over the medium term. Nevertheless, we are determined to limit and even reduce further the share of government in GDP over time. We expect that this will become easier with a return to brisk and sustained economic growth.

28.  During 2000-2001, we intend to continue modernizing our public finances and to address the existing structural weaknesses of the budgetary process. Some of these rigidities are dictated by our constitution--notably the significant degree of fiscal autonomy of local authorities--which restricts the ability of the central government to control general government finances. Nonetheless, there is room for improvement in a number of other areas. Specifically:

• To assist in the management of fiscal policy and to ensure a comprehensive overview of public sector operations the Ministry of Finance has started publishing monthly data on the basis of the fully consolidated general government as of May 1998;

• We will further improve cash and deposit management by the Treasury and by state agencies outside the Treasury framework. The distribution of central government deposits among domestic financial institutions will be governed by the principle of minimizing risk to taxpayer money. As of March 1, 1999, the Treasury started reporting publicly at the end of each month the amounts of central government deposits in each bank, as well as those held abroad. Moreover, the government in September 1999 approved general investment guidelines for all state assets. As an essential part of this new framework, the Ministry of Finance set up a Risk Management Committee (RMC), that includes representatives from the Ministry of Finance and the Bank of Estonia. The main task of the RMC is to oversee risk management practices relating to the investment of state assets by both the Treasury and other government agencies. The statutes of the RMC have been approved together with detailed risk management guidelines for the Treasury;

• In recognition of the importance for the execution of fiscal policy of fully integrating local authority financial operations into the general government budgetary framework, the government and the Bank of Estonia will continue to monitor local authority borrowing with a view to preventing the incurrance of new debt that is regarded as excessive in relation to local budgets or the overall stock of local and national debt;

• We are drafting, with technical assistance from the IMF, a new Basic Budget Law, that will, inter alia, provide for the inclusion in the central government budget of the utilization of all foreign loans and grants and gaining greater control over local authority budgets, including their borrowing programs. The new law will be submitted to parliament by June 30, 2000. This measure is also a structural performance criterion.

Monetary and Financial Policies

29.  The government and the Bank of Estonia remain fully committed to the maintenance of the currency board and the current fixed relationship between the kroon and the DM and euro. We believe that this provides an appropriate framework for the preparation for accession to the EU and for full participation in ERM2.

30.  The strategic aim of the Bank of Estonia over the medium term is to ensure the readiness of Estonia's monetary policy framework to join the European Union by January 1, 2003. To that end, the Bank of Estonia, will, in cooperation with relevant EU institutions, prepare during the course of 2000 a detailed analysis of Estonia's monetary legislation to guarantee full conformity with EU legislative requirements. Any necessary legislative changes will be submitted to parliament by December 31, 2000.

31.  The Bank of Estonia's overall objective in managing the financial system is to guarantee that the banking system is well-managed, maintains sufficient capital and liquidity to withstand internal or external shocks, and that the Bank of Estonia is able to monitor developments in a timely and effective fashion so that it can take early remedial action should the need arise. To that end, the Bank of Estonia will, during the program period, strengthen the operation of the currency board and the financial system by reviewing the operation of the prudential framework, upgrading its monitoring and analytical capacities, and ensuring appropriate levels of central bank reserves in excess of currency board cover to help deal with any unforeseen shocks. Specifically, the Bank of Estonia will:

• finalize by March 31, 2000 the review of the current structure of reserve requirements and additional liquidity requirements and introduce the relevant changes by June 2000 with the aim of reducing market distortions inherent in the current monetary framework. In particular, we will review the adequacy of the current rate at which commercial bank deposits at the Bank of Estonia are remunerated, the categories of assets eligible for meeting the reserve requirement, and the method of calculating liabilities subject to the reserve requirement. These changes will not compromise the level of liquidity buffers of the currency board system. No changes are foreseen in the capital adequacy ratio, which will remain at 10 percent of risk-weighted assets;

• introduce by March 31, 2000 an enhanced internal Early Warning System to detect in good time difficulties faced by the financial system;

• develop by December 31, 2000, together with the government, a common framework for addressing solvency and liquidity crises in the banking system with the aim of creating a transparent environment for ensuring the stability of and confidence in the banking system. In developing such a framework, due account will be taken of the basic principle that addressing strictly short-term liquidity difficulties would normally be the responsibility of the Bank of Estonia and that all other demands would fall on the budget. Moreover, the currency board arrangement strictly limits the financial scope for intervention by the Bank of Estonia. Intervention should thus be entertained only when crises take on a clearly systemic character;

• complete by December 31, 2000 a study of the terms and the structure of private sector credit lines and other market-based instruments presently used by the public sector and the private sector (especially commercial banks). This study will evaluate the resilience of the Estonian financial system to internal and external shocks and its ability to ensure access to adequate financing in times of market disruption. The material strengthening of the banking system through the process of consolidation in the period through 1998 and the entry of foreign strategic investors provides an important opportunity to work, together with commercial banks, toward a more robust financing environment. In addition, the Bank of Estonia will intensify contacts with key private creditors to the banking system to guarantee an appropriate and timely exchange of information.

32.  The Bank of Estonia established in October 1999 a framework for profit transfers to the state budget that takes account of the need to maintain sufficient medium-term central bank capitalization and provides for an adequate level of net international reserves over the minimum currency board coverage consistent with the Law of the Bank of Estonia. Within this framework, the profit transfer to the state budget will be limited to up to 25 percent of the Bank of Estonia's annual profits in the years ahead.

33.  The difficulties faced by the banking system in 1997 and 1998 have strengthened our determination to improve further the regulatory and supervisory environment of our banking system and to make the financial system more transparent. To that end, we have taken the following measures to strengthen supervision:

• The Bank of Estonia introduced bank supervision on a consolidated basis in early 1998 and has been refining associated procedures on an ongoing basis. Further improvements are planned in this field, e.g., in on-site supervision of consolidated institutions as well as in the improvement of the analytical basis for the off-site supervision of consolidated groups;

• A revised Credit Institutions Law was made effective on July 1, 1999. This law materially strengthens the ability of the Bank of Estonia to enforce prudential standards and helps bring the supervisory standards into compliance with the Basle Core Principles, and internationally accepted practices;

• We implemented in October 1999 revised disclosure requirements for commercial banks reporting on a comprehensive and uniform basis, including bank's off-balance sheet exposure in annual reports. The first reports based on the new disclosure requirements will be published by end-February 2000;

• We revised in October 1999 the regulatory framework to make full use of the possibilities afforded by the new Credit Institutions Law. Specifically, we introduced new or revised regulations relating to the licensing of new banks, "fit and proper" criteria for bank owners and managers, and the circumstances under which holdings in banks in excess of 10 percent of total capital can be acquired or increased;

• To facilitate supervision on a consolidated basis, the Bank of Estonia has prepared a manual with the complete set of internal regulations and will update and make any other necessary changes to this manual as and when required.

To further raise standards of bank supervision, the Bank of Estonia will also take the following measures:

• Implement by March 31, 2000 an improved loan assessment framework, including a uniform minimum loan-loss provisioning system that provides scope for partial provisioning;

• We currently have a two-tier system in place for the evaluation of country risk and transfer risk components in the capital adequacy calculation. We intend to review the need to introduce a more articulated framework for this calculation. If necessary, we will introduce the new framework by September 30, 2000;

• To maintain a high standard of supervision, the Bank of Estonia also remains committed to keeping the supervisory department appropriately staffed.

34.  Although considerable strides have been made in bringing the supervision of the banking system up to international standards, the supervision of nonbank financial institutions--especially the securities industry--remains weak. The government and the Bank of Estonia have decided on a comprehensive strategy for the consolidation of financial sector supervision under one independent agency (the "agency") under the public law to ensure that supervision over all financial operations in Estonia is conducted at a high and uniform standard. With this objective in mind, and cognizant of the importance to the economy and the financial sector of ensuring that the legislative, institutional, and organizational foundations of the agency are well founded, the government and Bank of Estonia intend to take the following measures in preparation for establishing the agency:

• The government has already submitted to parliament the new Insurance Business Law in September 1999 and will submit to parliament the new Securities Market Law by June 30, 2000. These laws will establish minimum standards, especially as regards regulation of primary and secondary markets, avoidance of insider trading, and ensuring that minimum capital and capital adequacy requirements are met. They will also provide supervisors with sufficient authority and autonomy to effectively enforce these standards. These laws have been drafted consistent with EU guidelines;

• The government and the Bank of Estonia is establishing a joint working party to prepare by June 30, 2000 the organizational and legal principles under which the agency would be established and draw up a detailed action plan for setting up the new agency. In recognition of the key role played by the banking sector in ensuring macroeconomic stability and the viability of the currency board, we will ensure that there will be no compromise in the standard of commercial bank supervision during the transition to a unified supervisory environment;

• In addition, we will by June 30, 2001 submit to parliament all the necessary legislative measures associated with the establishment of the agency.

35.  The Compensation Fund was established in 1993 to serve as a mechanism for the redemption of restitution and national capital vouchers that were not used to acquire privatized housing, land, or equity in public share offerings. Under current legislation, these vouchers are due to expire on December 1, 2000. We expect that further Compensation Fund bond issues in the amount of about EEK 150 million will be made in the period through September 2000 after which no further issues will be made. The government thus deems that the work of the Compensation Fund will have been essentially completed and intends to terminate its operations. To that end, further transfers of privatization proceeds to the Compensation Fund have been halted effective January 1, 2000. The government will by June 30, 2000 complete a review of the financial and legislative consequences of winding up the Compensation Fund and will in due course propose legislation to parliament that would authorize the restructuring of the Compensation Fund. We intend to make adequate financial provision for the servicing of all Compensation Fund Bond issues through their final maturity. Allowing for the maintenance of a reserve to redeem at market value any outstanding vouchers at the end of the voucher program, it is estimated that the Compensation Fund will have assets in excess of its liabilities amounting to approximately EEK 500 million. The government's intention is that the bulk of these surplus resources will eventually be transferred to the Stabilization Reserve Fund.

36.  In November 1998, the Bank of Estonia acquired at a cost of EEK 255 million a controlling interest in the Optivabank as part of a bank rescue and restructuring exercise. The Bank of Estonia believes that the interests of the Estonian banking system would be best served if its equity share in this bank were to be purchased by an appropriate strategic investor. The Bank of Estonia is firmly committed to the privatization of its equity stake and will continue its effort to seek a fitting buyer for Optivabank. Market conditions permitting, we expect that the sale will be concluded by June 30, 2000. In addition, the Bank of Estonia completed the disposal of its modest stake in Hansapank in December 1999.

Other structural policies

37.  Estonia has benefited from its liberal trade policies since the beginning of transition. In particular, the absence of any import tariffs has minimized distortions in the domestic economy and has helped establish Estonia's reputation as a bold reformer. This policy was of considerable help in our accession to the WTO. Estonia was formally accepted into the WTO on November 13, 1999. However, as EU membership is drawing near, we need to prepare for harmonizing our trade policies with those in the EU. In part to demonstrate Estonia's ability to administer a comprehensive trade and tariff regime, the government has effective January 1, 2000 introduced tariffs that apply mainly to agricultural products. These tariffs do not apply to imports from EU countries or from those countries with which Estonia has concluded free trade agreements. Tariffs are at or below the binding limits agreed with the WTO (which are below EU tariff rates). Our next priority will be to prepare and announce our medium-term strategy of trade policy harmonization, so as to clarify our intentions vis-à-vis our trading partners, as well as to create a transparent, stable, and predictable policy environment for domestic producers and consumers.

38.  Following a World Bank public expenditure review in 1997, we identified priority measures for rationalizing the public administration and increasing transparency in public employment and remuneration. We already established in December 1999 two departments within the Ministry of Finance that are charged with ensuring that spending by government units (including ministries) is consistent with budgetary objectives, making certain that these units are being managed in an appropriate fashion, and monitoring the use of EU resources. We also established in late 1999 an Administration Reform Bureau within the government responsible for developing and implementing its public sector reform strategy. The main goals of the Bureau are to streamline and rationalize the central government and to realize efficiencies in the structure of local authorities and other agencies of the government, including through mergers. Financial incentives will be employed where deemed appropriate to expedite this process. In addition we will also complete by September 30, 2000 a review of employment in the large education sector.

39.  In 1997, we started the reform of our pension system with a view to creating a three pillar system: (i) the first pillar would be a modified version of the existing defined benefit program financed on a Pay-As-You-Go basis, (ii) the second pillar would be a compulsory and fully-funded defined contribution program, and (iii) the third pillar would be a voluntary private pension system, with contributions enjoying a tax advantaged status. The government is receiving technical assistance from the World Bank to help frame these reforms and has also sought assistance from the IMF.

• We are proceeding with the reform of the first pillar. Effective with the budget for 2000, pension contributions on behalf of selected disadvantaged groups (including the unemployed) will be financed from general tax revenues. On April 1, 2000, we will also provide, inter alia, for (i) the introduction of an earnings based component for new pensioners based on the individual registration of pensions that started in 1999 (this adjustment will be implemented in a cost-neutral fashion) and (ii) the indexation of pensions starting in 2001. Moreover, no general increase in pensions is foreseen for 2000. The retirement age has been progressively increased starting in 1994; in December 1999 the retirement age was 62 ½ years for men and 57 ½ years for women. The retirement ages for men and women will be equalized at 63 years in 2016;

• We intend to introduce the second pillar late in 2001 or early in 2002. To that end, by early 2000 and in cooperation with the IMF and World Bank, we will complete detailed long-term projections of the finances of the first and second tier under alternative assumptions. Not later than December 1, 2000 we intend to submit to parliament legislation that determines the eligibility rules and formula for the calculation of second pillar benefits, as well as the guidelines for management of second pillar funds;

• The third pillar has already been put in place with the promulgation by parliament of the Pension Fund Law in June 1998. As at November 30, 1999, one pension fund and several life insurance companies (licensed to provide annuity products) have started operations.

40.  In 1997, we launched a major reform of Estonia's health system with the assistance of the World Bank. In several areas, notably primary health care, significant progress has already been made: a family physician system has been introduced, and family physicians now provide about one-third of primary health care in Estonia and act as gatekeepers for specialized medical care. The next major step is the reform of the financial aspects of the health system, including the operation of the Medical Insurance Fund. The financial management of hospitals has started to improve already as subsidization of their utility bills has stopped. In addition, by June 30, 2000 we will formulate a restructuring and investment program for Estonia's hospital network with the aim of improving efficiency and reducing costs. This program would be subject to a phased implementation over the period 2001-2015.

41.  Estonia is now at the final stage of its privatization program, with only a few large enterprises and public utilities remaining in state hands. The work of the Estonian Privatization Agency has therefore been deemed to have been completed and the government will wind up its operations by December 31, 2000. As regards the remaining equity the state holds in the enterprise sector, we intend to make further progress in the sale of these interests, while according the highest priority to the quality of privatization and the proper safeguarding of privatization receipts. In the nonenergy sector we intend to take the following steps:

• The sale of 24 percent of shares in Eesti Telekom in February 1999 reduced the state's holding in the telecommunications complex to 27.3 percent, plus a "golden share" that gives the state control over a limited list of strategic corporate decisions in the period through December 2003. The government will decide by September 30, 2000 on a timetable for the sale of its remaining financial interest in Eesti Telekom;

• In 1997 the Estonian railway complex was split into several operating companies and a railway repair and maintenance facility to facilitate its rationalization and privatization, which is proceeding broadly on schedule. The responsibility for the privatization of the most important of these operating companies, Eesti Raudtee--the major freight and transit line--was transferred to the Estonian Privatization Agency in August 1999. We are in the process of completing work, with the assistance of the EBRD, on the identification of the assets that would be included in the package to be tendered (including land holdings). We will also need to decide whether to privatize the entire company as a whole. The privatization of Eesti Raudtee is expected to be concluded by December 31, 2000. The privatization of the passenger network (Edelaraudtee) is well advanced, with discussions proceeding with an interested investor on the scope of future passenger operations in Estonia;

• The Port of Tallinn, which is responsible for the operation of four separate ports in the immediate vicinity of Tallinn, remains wholly owned by the state. In the interest of creating a competitive, efficient, and transparent environment for the transport of both passengers and freight--which will become increasingly important as other Baltic ports start competing for the same markets--early consideration would also be given to the privatization of a 30 percent stake in the Port of Tallinn to improve transparency and corporate governance.

42.  Considerable effort has been devoted over the past several years to the rationalization and privatization of the Estonian energy complex. Some progress has already been made with the closure of several oil shale mines. However, more needs to be done. It is recognized that the need to resolve interrelated economic, social, and environmental issues has substantially slowed down agreement on a permanent solution. The government's broad objectives have been (i) to create a competitive market for the generation, transmission, and distribution of electric power to protect consumers and support the further development of Estonian industry through ensuring reliable energy supply at competitive prices, (ii) to address the substantial overmanning in power generation and oil shale production sectors, while protecting a region hit hard by the Russian crisis and already suffering from substantially higher unemployment than the rest of the country, and (iii) to reduce the intolerable pollution of the air, water, and land resources in the northeast of the country associated with the production of oil shale and the generation of electricity using existing technologies. To address these important concerns, the government has decided to implement an ambitious and integrated program with the following key elements:

• The government expects to conclude by June 30, 2000 an agreement in principle to initiate the privatization of the energy sector through the sale of a 49 percent interest in Narva Power Stations to NRG Company (a US based energy company) with the majority interest being retained for now by the wholly state-owned Eesti Energia. While Narva Power Stations will be responsible for the bulk of electricity generation in Estonia, as well as the mining of oil shale, Eesti Energia will remain responsible for the operation of the national transmission system as well as most of the nation's distribution companies. As part of this package, Eesti Energia is expected to agree to purchase from Narva Power Stations a fixed quantity of electricity annually--equivalent to about 75 percent of the national electricity market for an initial period of 7-8 years and about 50 percent of the national electricity market thereafter through 2014--at a preagreed price (based on a cost-plus formula). The remaining share of the national electricity market (initially of up to about 25 percent) is being reserved for electricity producers that may wish to enter this market in the future.

• The new Energy Act which became effective January 1, 1998 has substantially raised the standards of regulation in the energy industry. It puts a premium on ensuring a high degree of competition among energy producers with the aim of keeping energy costs low and in this way contributing to keeping the Estonian economy competitive. An Energy Inspectorate has been established under the Ministry of Economy to implement the regulatory framework of this Act. Although the Inspectorate has made a credible start to its work, the government recognizes that the forthcoming reorganization of the electricity sector will create new challenges for the Inspectorate, including ensuring open and fair access to the electricity transmission and distribution systems in a setting where Eesti Energia will retain a major role at every stage of the process of producing and selling electricity in Estonia. To enable the Inspectorate to fulfill its responsibilities in this setting an early upgrading of its technical and oversight capabilities will be required. The government is committed to an immediate review and implementation of measures required to raise the Inspectorate's regulatory capacity to the standard required to give full effect to the open energy market as foreseen in the Energy Act and will provide the Inspectorate with sufficient resources to carry out this mission by June 30, 2000. The government will also keep under review the option of privatizing the national transmission system and the distribution companies still under the aegis of Eesti Energia in the event this is seen as necessary to further strengthen competition;

• This ambitious program of privatization and restructuring of the production of oil shale and generation of electricity is likely to generate economic dislocation in the northeast of Estonia, including greater unemployment. In the government's view the recovery of this region will require creating an environment conducive to the rapid and widespread development of the private sector. In particular, growth of a vibrant small- and medium-sized enterprise sector will need to make an important contribution to creating jobs for workers displaced from the energy complex. The government will seek the assistance of the World Bank in developing a framework for the development of this region. This will also be supplemented by a number of largely private sector initiatives to promote small scale enterprises to help absorb labor shed through the restructuring of the energy complex. In addition, the government is encouraging the development of new commercially viable industries that utilize oil shale so as to mitigate the impact on the mining industry of the rationalization of electricity production.

  43.  Although the state has virtually completed the privatization process, a number of municipalities and local governments still retain substantial interest in enterprises that are active in areas normally in the domain of the private sector (most are understood to be relatively small). With a view to establishing a timetable and effective mechanism for the privatization of all such enterprises, the government will require municipalities and local governments to catalogue all enterprises in which they have a material interest--subject to a minimum annual sales volume of EEK 250,000--and submit such list to the Ministry of Finance by September 30, 2000.

IV.  Performance Monitoring, Program Review, and Availability of Purchases

44.  Progress in the implementation of the policies under this program will be monitored through quarterly quantitative performance criteria, structural performance criterion and benchmarks, and two program reviews. The first review is expected to coincide with the 2000 Article IV consultation discussions, and will focus particularly on the evolution of Estonia's fiscal position, the pace of economic recovery and its impact on the balance of payments. The review is expected to be completed with the Executive Board of the Fund by June 30, 2000. The second review would focus on the budget for 2001 and is to be concluded by December 15, 2000. Quarterly quantitative performance criteria will apply to (1) the minimum level of net international reserves; (2) the overall balance of the general government; and (3) contracting or guaranteeing by the general government of external borrowing, with separate subceilings on borrowing of maturities of two years or less, and from two to ten years. In addition, gross foreign reserves of the Bank of Estonia must equal (or be greater than) the currency board's liabilities at all times. Furthermore, the government undertakes not to accumulate any external payments arrears at any time during the program period. The structural performance criterion relates to the submission to parliament of the Basic Budget Law (paragraph 28 above). These performance criteria are elaborated in the Annex to this Memorandum, which also contains a listing of structural benchmarks under this program.