Public Information Notice No. 05/152

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Republic of Estonia

November 4, 2005

On October 26, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Estonia.¹

Background

Estonia has made extraordinary progress following independence. Sound macroeconomic policies and far-reaching structural reforms have resulted in the successful establishment of a market economy and EU membership. The country is witnessing a remarkable convergence in real terms to EU levels, with purchasing power parity per capita income increasing to 46 percent of the EU15 level. Estonia has also achieved significant nominal convergence, meeting all of the Maastricht criteria, save for inflation. Estonia entered ERM II in late June 2004, unilaterally maintaining its peg to the euro with a currency board arrangement, and is aiming at early euro adoption.

Robust economic growth continues, largely driven by domestic demand. Real GDP growth increased to nearly 8 percent in 2004 (from 6¾ percent a year earlier) and accelerated further, to 8½ percent year-on-year, in the first half of 2005. Inflation has increased since mid-2004 and remains significantly above the Maastricht criterion. Headline inflation reached 4.9 percent year-on-year in September and, with current policies, is forecast to remain above the Maastricht criterion by the time of the earliest possible test date in mid-2006. At the same time labor market conditions have tightened: in the second quarter of 2005, the unemployment rate declined to 8.1 percent, overall employment continued to grow and wages increased by 11 percent. With output estimated to be close to potential and labor shortages appearing in the construction sector, signs of nascent overheating are emerging.

The current account deficit remains large, increasing external vulnerabilities. Despite strong export growth, the current account deficit widened to 12.7 percent of GDP in 2004. However, on the heels of a strong export performance, it subsequently declined to 10.4 percent of GDP in the first half of 2005.

Following four years of tight fiscal policy, the fiscal stance eased in 2004, and is projected to ease further in 2005. The fiscal surplus declined to 1.7 percent of GDP in 2004 when the government increased expenditures in a supplementary budget late in the year. As a result of higher pension expenditures planned for the second half of this year, and a recent supplementary budget allocating a good part of revenue overperformance to additional spending, the fiscal surplus will decline again in 2005 to a projected 0.4 percent of GDP. The 2006 budget foresees a further easing to an overall balanced position.

The rapid expansion of credit to the private sector continued in 2004 and the first half of 2005, financed increasingly by borrowing from abroad. Credit growth to households accelerated to above 50 percent in 2004, year-on-year, with household loans for real estate accounting for over 80 percent of this. Credit growth to enterprises reached 48 percent at end-June 2005 from around 25 percent a year earlier. Estonia's banking system remains financially sound, with strong profitability continuing despite increased competition. Confidence in the currency board remains strong.

Executive Board Assessment

The Executive Directors commended the authorities on the remarkable progress Estonia has made in the 14 years since independence, which has been made possible by sound macroeconomic policies and far-reaching structural reforms. These policies have achieved sustained growth and declining unemployment, and the country is rapidly converging to EU levels. Directors considered that the economic outlook is generally favorable, but noted the nascent signs of overheating, including the rapid growth in domestic credit, and the country's continuing external vulnerabilities. In these circumstances, Directors called for fiscal restraint and careful monitoring of credit developments in the short term, and continued efforts to maintain product market and wage flexibility for safeguarding competitiveness.

Many Directors viewed the continuing large current account imbalance with concern. The current account deficit has been at a level that is unsustainable over the longer-term and needs to be addressed. Directors noted that the deficit did not appear to stem from any problems of competitiveness, but has rather been influenced by macroeconomic conditions. They emphasized that, in the context of Estonia's currency board, fiscal restraint is needed to restrict domestic demand and reduce the external imbalances.

Directors commended the authorities for their pursuit of prudent fiscal policy over several years. At the same time, they noted that the decline in the fiscal surplus in 2005, and the further decline planned in 2006, meant that fiscal policy will continue to impart a positive fiscal impulse when the economy is showing signs of overheating and external imbalances are large. Furthermore, they noted that, in Estonia, fiscal policy is the only effective stabilization tool. In these circumstances, Directors considered that fiscal policy should be tightened. Should any windfall revenues occur, they should be saved and the expansionary effects of the recent supplementary budget should be reversed in 2006 to limit demand pressures. Directors welcomed the plans to introduce medium-term budgeting aimed at improving expenditure control. They agreed that the medium-term budget should target balanced budgets over the cycle enabling a gradual reduction in the fiscal surplus.

Directors noted that the banking sector remains sound, with strong bank balance sheets, good supervision, and well developed risk management systems. Nevertheless, they expressed concern about the high growth rate of credit, especially as much of the increase in domestic credit is funded by foreign borrowing and used to finance credit to the domestic real estate market. Directors agreed with the authorities that, in the absence of an independent monetary policy, large scale measures to restrict credit growth are largely precluded. Still, they urged the authorities to use all tools at their disposal to reduce the demand for credit, including by tightening prudential regulations should banks loosen their credit standards. Accordingly, Directors welcomed the authorities' intention to remain vigilant and stand ready to implement any needed measures. They also welcomed the authorities' progress on implementing Anti-Money Laundering/Combating Financing of Terrorism legislation in line with international norms.

Many Directors observed that, while inflation is relatively high, it is not seen as a threat to competitiveness as it is declining and core inflation is under control. Nevertheless, it will be challenging for Estonia to meet the Maastricht inflation criterion in 2006, although Estonia has otherwise achieved an impressive degree of convergence toward the euro area. Directors observed that the currency board remains credible, as indicated by Estonia's relatively high credit rating, and is a viable strategy in the run up to euro adoption.

Directors observed that flexible labor and product markets are critical in a country where there is no nominal exchange rate flexibility and, consequently, it is important for Estonia to maintain the high degree of market flexibility that has been achieved. They also noted the need to keep wage increases in line with productivity increases, if Estonia is to remain competitive. Directors were supportive of Estonia's recent steps to increase employment through active labor market policies. They also welcomed the planned reforms to increase competition in the electricity and telecommunications sectors.