On May 05, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with the Republic of Estonia.
In 2013, Estonia’s recovery from the crisis continued but at a slower pace. Real GDP growth was 0.8 percent, with private consumption providing the main support while net exports made a negative contribution. Inflation declined to about 3½ percent, but stayed above the euro average. Public finances remained strong, with a fiscal deficit of 0.2 percent of GDP, a gross public debt of 10 percent of GDP, and a net public debt near zero. Unemployment continued to fall, bringing the unemployment rate down to 8.6 percent, about half the 2010 peak. Nominal wage growth accelerated, outstripping productivity growth and putting pressure on price competitiveness. The current account deficit was small, and the net international investment position improved. Gross external debt fell sharply in 2013 and net external debt of the economy turned negative.
Economic activity should pick up in 2014 and the medium-term, supported by both external and domestic demand. Real GDP growth is projected at 2.4 percent in 2014, rising toward expected potential growth of 3 to 3.5 percent in the medium term. The downward trend in inflation is expected to continue toward 2 percent over the medium term, but could be slowed by increased wage pressure. Risks to the outlook are tilted moderately toward the downside and mostly relate to trade. In particular, less favorable than projected economic conditions in the Nordic Baltic region and the CIS could slow Estonia’s growth through lower exports or FDI. Also, a rise in interest rates from a shock in the Nordic banking system could adversely affect Estonia. Finally, labor market overheating could also undercut competitiveness and export growth.
Estonia’s policy agenda is characterized by continuity in policies. With a projected fiscal deficit of 0.4 percent of GDP in 2014, the fiscal stance will remain appropriate given cyclical conditions. Over the medium term, the authorities’ structural surplus targets will keep the government’s balance sheet strong and allow automatic stabilizers to operate fully in case of downturns. However, the government should refrain from additional large wage hikes which could have demonstration effects. In the financial sector, the envisaged early implementation of the new capital and liquidity provisions under Basel III will further enhance Estonia’s financial stability. Also, a close collaboration with the ECB and the Nordic -Baltic supervisory structures will be important to smooth Estonia’s transition to the Banking Union. Estonia’s high level of structural unemployment needs to be addressed. In addition to the current active labor market policies to reduce skills mismatches and keep people in the labor force, lowering the tax wedge on lower-wage workers could further reduce unemployment. Finally, Estonia should coordinate with its Baltic and Nordic neighbors to diversify infrastructure, which could also boost competitiveness.
Executive Directors commended Estonia’s continued commitment to sound macroeconomic policies. Directors noted that while the outlook for growth is favorable, risks are tilted to the downside because of the difficult regional environment. They emphasized the need to maintain strong macroeconomic policies to preserve competitiveness, address the high unemployment rate, and enhance long-term growth.
Directors welcomed the 2014 budget, which continues Estonia’s tradition of prudent fiscal policy characterized by low deficits or surpluses, and low debt. They considered the budget’s underlying stance to be broadly appropriate and consistent with prevailing economic conditions. Directors agreed that the creation of the fiscal council and the structural surplus target embodied in the new Budget Law should help address the previous pro-cyclical patterns of fiscal policy by preventing unsustainable increases in expenditure during good times, and provide scope to allow automatic stabilizers to operate in downturns. More broadly, Directors underscored that fiscal policy should be flexible and growth friendly.
Directors welcomed the authorities’ commitment to maintain a strong financial system in the face of the evolving financial architecture, including the planned early implementation of the new capital and liquidity provisions. They advised close collaboration among the Estonian authorities, the ECB, the Nordic-Baltic sector supervisory, and governmental structures to ensure that Estonia’s transition to the Banking Union is smooth. In the context of a strengthened macroprudential framework, developments in housing prices should be closely monitored.
Directors emphasized the need to preserve competitiveness in light of recent increases in wages and unit labor costs. While acknowledging that wages are largely market determined, they encouraged the authorities to refrain from additional large public sector wage hikes or agree to minimum wage increases, until it is clear that the wage rates are not undercutting net exports.
Directors agreed that Estonia’s high level of structural unemployment needs to be addressed. They noted that some policies to address skills mismatches and maintain labor participation rates are already in place, and that funding for these programs has been substantially expanded. Directors agreed that further efforts to improve the skills of those already working and increase the number of people with education in technical fields should reduce the shortage of highly-skilled workers and boost productivity. They also recommended reducing the tax wedge on lower-wage workers in a budget-neutral manner, which would contribute to containing unit labor costs and improving competitiveness.
Directors agreed that regionally-coordinated efforts to improve infrastructure links to Estonia’s neighbors could help improve competitiveness and better connect with the rest of the European Union.