July 22, 2005
1. Estonia has made enormous economic strides since independence. Sound macroeconomic policies and far-reaching structural reforms have been the key to this by fostering macroeconomic stability and promoting strong growth. As a result, the country is rapidly converging to EU levels, with purchasing power per capita income approaching half the EU15 level in 2004 from about one third in 1995. And Estonia is leading the other new EU member states in meeting the Maastricht criteria. The country entered ERM II in late June 2004, unilaterally maintaining its euro-pegged currency board, and is well positioned to adopt the euro as planned.
2. While economic developments in Estonia are generally favorable, the future is not without risks, with nascent signs of overheating in some sectors. For a country at Estonia's stage of development, some inflation is to be expected as productivity-led wage increases spread throughout the economy. In a small open economy with a currency board arrangement, inflation is in large measure determined by external factors. Notwithstanding this domestic policy does have some effect. While the ..............
............... core inflation rate is currently low at about 2 percent, an expansionary fiscal stimulus, especially if combined with rapid credit growth, could result in inflationary pressure. And vulnerability to external shocks remains, with a relatively large current account deficit that is increasingly financed by borrowing from abroad. Again, for a country in Estonia's position, some current account deficit is to be expected as the country increases its productive capacity by importing capital equipment. But, in our view, the current account is currently at an unsustainable level.
3. To ensure the smooth adoption of the euro and solid economic performance thereafter, prudent policies need to be pursued to keep inflation in check and to allow the external imbalances to return to sustainable levels. In the short-term, with the economy near potential and early signs in the real estate and construction sectors that the economy may be facing some bottlenecks, fiscal tightening is called for. This would reduce domestic demand and the external imbalances as well as forestall inflationary pressures. The pace of growth of domestic credit should be monitored carefully and the authorities should be prepared to make use of all available tools, including prudential regulations, if there are signs that credit standards are easing and the rapid price run up in asset markets poses systemic financial risks. Looking beyond the short-term, maintaining product and wage flexibility is paramount in preserving Estonia's competitiveness and facilitating convergence.
4. The macroeconomic outlook for 2005 remains favorable, but with some upside risks for inflation. Real GDP growth is projected to be about 7 percent in 2005, driven by domestic demand with some support from the external sector, although the latter is subject to downside risks in light of the weaker than expected external environment. Average headline inflation is projected to accelerate to about 3½ percent from 3 percent in 2004, as a result of rapidly growing energy prices, increased administered electricity prices, and EU-related increases of tobacco and fuel excises. Inflation is projected to lessen somewhat in 2006. However, there are risks that continued rapid credit growth and further fiscal stimulus could fuel second-round effects and result in higher inflation in 2006 when Estonia will be evaluated for adoption of the euro. The current account deficit is projected to decline to about 11 percent of GDP in 2005, with private saving expected to recover with the expansion of the second-pillar of the pension system.
5. Given the limitations of the currency board on an independent monetary policy, tight fiscal policy is the only effective tool available in Estonia to reduce external vulnerabilities and restrict domestic demand. Expenditures should be closely monitored and any excess revenues—which have often occurred in past years—should not be spent but rather be used to accumulate financial assets. At a minimum, a fiscal surplus of at least the same size as that achieved in 2004 should be targeted in 2005, thereby assuring a neutral fiscal stance.
6. The announced increase of the basic pension in 2006 (amounting to around ½ percentage points of GDP) could put pressure on the fiscal balance despite the higher revenues expected from a slower pace in the reduction of the tax rate on income. Moreover, some of the proposed revenue measures (for example, higher excises and increased dividends from state-owned companies) have undesirable side effects. While, in principle, the mission supports the authorities' plan to shift the tax base towards indirect taxes over the medium term, it suggests adhering to the original timetable for excise increases to avoid adverse inflationary consequences in the run-up to euro adoption. And the government's plans to increase dividend withdrawal from the state-owned electricity company might prove counterproductive at a time when significant investment funds are required. Therefore, if the pension increase is to be implemented, sufficient cuts in other expenditures should be taken in order to avoid further fiscal stimulus.
7. Greater efforts to control government current expenditure are also called for. The government's wage bill has increased significantly (by around ½ percent of GDP) in recent years as a result of increases in health and education employment and a sizeable increases in healthcare wages. Given the increase in the size of the government over the past several years, controlling expenditure growth, especially in light of growing demand for healthcare services in Estonia's rapidly aging population, should be improved to preserve the relatively favorable tax environment which has been clearly beneficial to Estonia over the past decade. In this regard the mission was pleased to find the necessary preparations for medium term budgeting are now in place and encourages the authorities to implement this in the next budget cycle. The authorities' undertaking to eliminate off-budget operations was also welcomed.
8. A rapid implementation of the authorities' medium-term balanced-budget target would provide excessive stimulus and exacerbate the external imbalance at a time when financial prudence is called for. While the target appears appropriate from a medium- to long-run perspective, it should be achieved only gradually, with a measured reduction in the fiscal surplus over the next several years to limit external vulnerabilities and support the timely adoption of the euro. Doing this will allow the authorities to set aside the surplus funds to provide for the future needs of an aging population.
9. While levels of credit in Estonia are low by EU standards and some relatively rapid credit growth is to be expected as the financial system converges to EU norms, there are emerging signs of overheating—real estate and equity prices are both growing fast and there are labor shortages in the building sector. The real estate market seems to be segmented and quality improvements are not taken into account in the price statistics; nevertheless, the rapid growth of real estate prices could potentially signal overheating and should be carefully monitored. This is particularly worrisome in the light of the brisk expansion of mortgages. If, in a fight for market share, the banks were to loosen credit standards, financial supervisors should use all of the tools at their disposal, including prudential regulations. Slowing the growth in housing demand could also be achieved by reducing further mortgage interest deductibility and freezing the housing activities of Kredex.
10. The strong performance of exports and relatively stable traded goods prices suggest that the current exchange rate peg is appropriate. There is no evidence that the current account deficit reflects a problem in competitiveness. Because Estonia has a currency board arrangement, maintaining labor and product market flexibility is crucial in preserving Estonia's competitiveness over the medium term and ensuring sustainable real convergence in the run-up to euro adoption and thereafter.
11. Labor market conditions continue to improve, but structural unemployment remains high and localized, in part a legacy of Estonia's past. The unemployment rate, according to the harmonized EU definition, declined by 0.6 percentage points to 9.5 percent in 2005Q1 compared to a year earlier, while employment continued to increase. The active labor market policies introduced in the autumn of 2004 have contributed to these positive developments.
12. Estonia is modernizing its vocational education system to increase school participation rates and enhance the system's responsiveness to labor market needs. The new vocational education development strategy for 2005-08 has been expanded and Estonia is preparing for the future use of EU structural funds to achieve the goals of the plan.
13. Reforms to increase efficiency and competition in network industries continue. Under the EU accession treaty, Estonia has been granted a transitional period for the opening of its electricity market with 35 percent expected to be opened to competition by the end of 2008 and a fully free market envisaged by the end of 2012. Developments to date are on schedule, with notable efficiency and environmental gains. Reforms in the telecommunication sector have contributed to economic expansion and have brought significant consumer benefits. Recent measures, including phone number portability, have further increased competition and reduced prices.
14. We commend the authorities for implementing market based policies that have led to the successful transformation of the Estonian economy that is enjoying robust growth and relatively stable prices. But full integration into the euro area is not yet complete and we urge the authorities to guard against complacency and to continue with their prudent policies.
We thank our many counterparts, in both the public and private sectors, not only for their generous hospitality and cooperation, but also for the interesting discussions during our visit in Tallinn.
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