The International Monetary Fund has applauded Estonia’s efforts to stabilize the economy, and suggest that euro adoption is within reach.
“A full-fledged crisis has been avoided due to existing buffers and a determined response by both the public and the private sector,” an IMF press release said. The full text follows:
Republic of Estonia—2009 Article IV Consultation Concluding Statement
Tallinn, October 26, 2009
1. Following a credit boom, the Estonian economy is now undergoing a severe recession. Domestic demand started to slow already in 2007, along with a bursting of the property bubble. The collapse of global financing and trade in the aftermath of the Lehman bankruptcy in September 2008 exacerbated the downturn. Economic activity has declined sharply, with output projected to drop by about 14 percent this year and unemployment is expected to exceed 16 percent by year-end. On the positive side, previous imbalances are correcting quickly: the current account should remain in a small surplus for the year and inflation is set to fall below the Maastricht criterion as early as next month.
2. A full-fledged crisis has been avoided due to existing buffers and a determined response by both the public and the private sector. Sizable fiscal reserves accumulated during the boom years, a very low level of public debt, and, importantly, swift and far-reaching fiscal adjustment measures taken in 2008 and throughout 2009 have helped the government avoid funding problems and keep alive hopes for euro adoption in 2011. The active use of EU structural funds provided some countercyclical stimulus at a time when supporting the currency board and securing speedy euro adoption necessitated a fiscal tightening. In the financial sector, banks’ own capital and liquidity cushions and support from Nordic parents prevented liquidity problems in spite of rising nonperforming loans; relatively high reserve requirements and a precautionary liquidity arrangement between the Estonian and Swedish central banks further boosted liquidity buffers of banks. The private sector has also reacted flexibly, with wage cuts and adjustments in employment, further enhanced by the new labor law. Estonia’s currency board arrangement has proven resilient to regional tensions.
3. As a result of present and past efforts, euro adoption in 2011 appears within reach. Following recent budget measures and assuming continued fiscal consolidation efforts, Estonia could meet all Maastricht criteria, while the policy record to date provides assurances for continued stability-oriented policies. This is remarkable, as it is being achieved against the background of severe dislocations due to the crisis. Joining the euro zone would remove residual currency and liquidity risks, adding stability to the Estonian economy.
4. But euro adoption is no panacea and the economic outlook remains challenging. While there are preliminary signs that the output decline is starting to bottom out, we expect the economy to resume growth only in the middle of 2010. Sluggish growth in Estonia’s main trading partners provides little room for an export-led recovery. The continued need for tight fiscal policies, and the high unemployment and debt burden will likely keep domestic demand subdued. The worsening of banks’ portfolios could limit the availability of fresh credit, including for viable projects. It is not certain that joining the euro zone, even if it goes ahead as planned in 2011, would by itself trigger a major change in the pace of recovery of Estonia’s economy, although some positive confidence effects can be expected.
5. Efforts —both by the government and the private sector—should focus on consolidating economic stability and laying the foundations for sustained growth. In particular, it will be key to:
• Gear fiscal policy not only towards meeting the Maastricht criteria in 2009-10, but to take measures now to secure sustainable public finances in the medium term;
• Further improve external competitiveness;
• Maintain appropriate buffers in the financial sector, while at the same time dealing with a high level of private sector indebtedness.
6. Following an extraordinary fiscal effort, the 2009 budget deficit is likely to remain close to its target of 3 percent of GDP. About one third of the adjustment in 2009 has been achieved through structural reforms, such as increases in VAT and excise rates, adjustment in benefits (pension, sickness, and unemployment), as well a consolidation of public functions. Another third is based on one-off measures, such as land sales, and larger than usual dividend payments by state owned enterprises. The remaining third relies on potentially reversible measures once the fiscal space should emerge (e.g., earmarked spending and postponed investment). Budget implementation in Estonia has held up remarkably well, given that the economic contraction has been only marginally smaller than in its Baltic neighbors. This can be attributed to a better starting position, strong budget institutions and tax collection. The procyclical impact on demand has been mitigated by the aggressive use of EU funding. Nevertheless, non-tax revenues, the health fund and deficits of local governments present considerable risks to meeting the budget targets. Continued consolidation at all government levels is warranted during the remaining months of the year.
7. Keeping the 2010 deficit below the Maastricht deficit limit presents a key challenge. Given the projected deterioration of the economy, notably a further rise in unemployment, achieving this target calls for an all-out fiscal push. The draft 2010 budget submitted to parliament goes a long way in offsetting these factors, primarily by further reducing operating expenditures while relying again on some one-off non-tax revenues. We believe, however, that current plans fall short of containing the deficit to below 3 percent of GDP. Given the considerable macroeconomic and implementation risks, additional measures of about 1 percent of GDP would provide an appropriate safety margin.
8. Credible medium-term stabilization requires to commit to additional structural adjustment measures now. While in current circumstances it seems appropriate to partly rely on measures with limited impact on domestic demand (such as dividends from state-owned companies and land sales), we see a strong case to supplement these with additional structural measures. The reason is that, once temporary measures expire in 2011, there is a high risk that large and widening headline deficits will emerge. Taking necessary structural measures already now would not only close the remaining budget gap for 2010 but also confirm Estonia’s medium-term commitment to fiscal sustainability—a key consideration when assessing preparedness for the euro. The short-term demand effect of those measures should not pose risks to 2010 growth, given the planned large increase in EU grant-financed government spending.
9. We see some room for further expenditure reductions. The size of government in proportion to the economy rose sharply already in the run-up to the crisis, especially after the 2007-08 surge in current spending. Better targeting of child and family benefits could deliver considerable savings. There may also be further scope for rationalizing public services and administration while improving efficiency and preserving important functions like tax administration. Pension reform represents an important medium-term goal.
10. Much of the adjustment effort will however need to fall on the revenue side. Following the boom years, which resulted in a surge of revenues, the tax base will be gradually eroded through the reorientation of the economy towards exports which are lightly taxed. In keeping with Estonia’s admirably simple tax system, a first step could be to further eliminate poorly targeted allowances and exclusions, especially within personal income taxes and VAT. Significant deferral benefits in the corporate income tax could also be reviewed. Consideration should be given to the further use of environmental and other taxes—such as an annual motor vehicle tax or real estate taxes—which would broaden the tax base and reduce economic distortions. An increase of the VAT rate would support a shift from nontradable to tradable sectors and could potentially be used to offset an increase of the personal income allowance or a reduction of Estonia’s relatively high payroll taxes.
11. The recent boom-bust experience calls for a new medium-term fiscal framework that limits the budget’s procyclicality. The “balance or better” fiscal rule served Estonia well, but could not prevent a surge in spending during the boom which proved painful to reverse during the downturn. Consideration should be given to strengthening multi-year expenditure ceilings, similar to what is used in some other EU countries. These could be supplemented with the existing goal to bring the budget to structural balance by 2012. The above-mentioned reductions in fiscal entitlements and broadening and diversification of the tax base would support this goal, as would a reduction of revenue earmarking.
Strengthening External Competitiveness
12. The economy needs to regain the external competitiveness lost during the boom years. The expansion in domestic demand put pressure on the labor market, and generated wage increases that ran ahead of productivity growth even in traded sectors not immediately affected by the credit boom. This dented Estonia’s external competitiveness, and has made it vulnerable to the large decline in external demand observed in the last twelve months. Depreciation of the currencies of some trading partners added pressures to Estonia’s external competitiveness, particularly in the early months of this year, although some of this has been recently reversed.
13. Policies that enhance economic flexibility are key to regaining competitiveness in the short and medium term, and will be equally important when Estonia joins the euro area. Labor and product markets are flexible, and seem capable of delivering the necessary adjustment in competitiveness. This adjustment is in fact already ongoing, as wages and prices have declined, and firms have tried to increase efficiency. In this context, the recent labor law was a step in the right direction, as it gives more flexibility to the labor market (although the corresponding social security component should be introduced as soon as feasible). Targeting EU-funded projects to the tradable sector should also help to deliver the necessary rebalancing of the economy, which in recent years tilted too much towards non-tradables such as real estate and construction. Active labor market policies and research investments will further promote Estonia’ competitiveness and economic convergence.
Financial sector and private sector debt
14. The financial sector has proven very resilient, despite pressures in the region. The systemically important banks maintain high levels of capital, which is partly due to a tax regime that has favored the retention of earning. Liquidity pressures have been contained through large domestic buffers, through parent banks’ enhanced access to wholesale funding markets (aided by the Swedish authorities’ supporting measures), and the precautionary swap agreement with the Riksbank. The strong bank supervisory framework in Estonia has helped to manage risks. Depositors’ confidence has been maintained despite regional uncertainties.
15. Caution is warranted, however, as rising nonperforming loans may nevertheless test banks’ resilience. Overdue loans are likely to increase further over the course of the year, amid limited near-term growth prospects and rising unemployment. This will necessitate banks setting aside additional provisions to assure that loan-loss reserves are maintained at adequate levels. While capital adequacy ratios are high and should provide a buffer against nonperforming loans, it would be prudent to step up macrofinancial supervision and to closely monitor developments, including whether debt restructuring agreements with clients are viable. Banks should provide debt restructuring and relief where warranted, and parent banks should stand ready to inject further capital if needed. Looking ahead, the provision of new credit is likely to remain subdued as banks adjust their balance sheets.
16. In light of the agreed EU roadmap and the crisis, implementation of further measures to strengthen the financial system must be accelerated. We welcome progress made in strengthening cooperation on cross-border financial stability in the Nordic region. Moreover, priority should be given to pending legislation on implementing a bank resolution framework and enhancements to the deposit guarantee fund, key recommendations of the last FSAP update. Complacency now would risk future problems being less tractable and thus undermine public confidence.
17. A large stock of debt by households and corporates, accumulated in the boom years, will weigh on growth. With non-financial sector loans at about 150 percent of GDP, private sector indebtedness is high in Estonia relative to its wealth and income level. Large proportions of long-term debt are currently tied to the depressed real estate sector. Financial difficulties of debtors may have eased somewhat recently, thanks to low interest rates and banks’ willingness to reschedule a portion of debt payments into the future. This relief is likely to be temporary, however, as price and wage deflation and increases in euro zone interest rates could result in a higher debt servicing burdens in the years ahead. International evidence suggests that high debt levels will slow recovery of consumption and investment.
18. While some debt restructuring and relief may be desirable from a macroeconomic perspective, heavy-handed policy intervention must be avoided. Any interference in private contracts, such as retroactive limits on debtors’ liabilities, would severely undermine Estonia’s tradition of the rule of law and may raise litigation risks. Imposing such provisions on new contracts would likely constrain the availability of credit. Appropriately designed credit enforcement legislation can, however, facilitate the rehabilitation of viable and speedy exit of non-viable firms and help good faith debtors make a fresh start. In this context, there appears to be room to optimize current legal provisions for foreclosure, bankruptcy and reorganization and their application through the courts. The Reorganization Act, in particular, may benefit from enhanced flexibility. Well-functioning insolvency frameworks also typically stimulate and support debt-reducing out-of-court restructuring. From a medium-term perspective, changes to the corporate tax code would be desirable to discourage excessive debt accumulation at firm level.
We would like to thank our many counterparts for their frankness and excellent cooperation.
IMF: Euro adoption in 2011 for Estonia appears within reach