Statement by David Farelius, Alternate Executive Director for Republic of Estonia
and Timo Kosenko, Advisor to Executive Director
October 26, 2005

Our Estonian authorities would like to express their appreciation to Mr. Haas and his team for the constructive discussions and the set of high quality papers. The authorities broadly agree with staff's assessment as well as with the recommendations for the years ahead.

Recent economic developments and prospects

Estonia is enjoying the sixth consecutive year of rapid economic expansion, underpinned by strong macroeconomic fundamentals, the EU entry and appropriately flexible market structures. In the current cyclical position, the real GDP growth reached 8.5 percent in the first half of 2005 and is expected to exceed 8 percent for 2005 as a whole. Thereafter the output expansion is expected to move closer to the long-term average that is revised upwards to 6-7 percent. While the domestic demand remains strong, the recent acceleration of growth is mostly accounted for by a buoyant export performance, contributing some additional 2 percentage points to the previous forecasts.

After the anticipated gradual decline during the first half of 2005, the rate of the annual CPI inflation picked up to 4.9 percent in September. The authorities have correspondingly changed their inflation forecast to 4.2 percent for 2005. This recent acceleration is mostly driven by the increase in oil prices. While the authorities remain vigilant to pre-empt possible second round effects, they are confident that the medium-term inflationary pressures remain modest. Moreover, as noted by staff in the Selected Issues paper, the impact of energy shocks on core inflation in Estonia has been low, likely reflecting the degrees of product market competition and labor market flexibility. Against this backdrop, the authorities expect the headline inflation to decline to somewhat above 3 percent in 2006, slightly lower than staff's projections, provided that oil prices will not reach new highs.

Long term confidence effects, rapid income growth and rising employment - in the context of full integration of Estonia's banking system with the European markets and favorable interest rate environment - have fuelled the private sector credit, particularly mortgage financing. By June 2005, the rate of credit expansion has leveled off at slightly above 40 percent year-on-year, with the accompanying rise in real estate prices remaining at the level of 20 percent. The authorities are well aware that vigilance is needed to avoid the possible undesirable effects of the rapid credit growth on the medium term developments. In this context, they take note of staff's suggestion to further reduce the tax deductibility of mortgage interest payments.

After peaking at 12.7 percent of GDP in 2004, mostly due to one-off shocks related to the EU accession and a number of large infrastructure investment projects, the current account deficit has remained on a declining trend with the four-quarter average decreasing to 10.4 percent of GDP in the first half of 2005. The deficit is expected to continue to decline gradually in the coming years, supported by the competitive export sector and gradually increasing domestic savings. Strong profitability of foreign-owned enterprises is expected to continue to have an impact on the headline deficit. As has been the case in the recent years, the reinvested profits will likely account for about half of the current account deficit (4.7 percent of GDP in 2004).

Staff notes the declining share of the net FDI in capital inflows. A significant part of this is attributable to increased FDI by Estonian companies. Moreover, the full integration of Estonia's financial system with European markets has resulted in substituting part of intragroup transactions for borrowing from Estonian subsidiaries and branches of large regional banking groups. Nevertheless, the authorities are fully aware that vigilance and prudent macroeconomic stance is needed to support the continuing decrease of the current account deficit.

Adoption of the euro

While the EU accession has provided a new impetus to the development of the economy and the society, the authorities recognize that the adoption of the euro would enable Estonia to reap full benefits of economic integration and the single market. Therefore, the adoption of the euro by 2007, in full compliance with the well known provisions of the common EU framework, remains an overarching goal for the Estonian authorities. Moreover, they are well aware of the need to maintain prudent macroeconomic stance and to continue with advanced structural reforms to ensure sustainable economic development and real convergence after joining the Euro Area. The authorities share staff's emphasis on maintaining labor and product market flexibility as the key to sustainable convergence in both the near and medium-term.

Estonia is expected to have little difficulties in meeting most of the Maastricht criteria. Estonian kroon has maintained its peg to the euro, including in the ERM II framework, the general budget has been in surplus for the past five years and the long-term interest rate differential with the euro rates remains negligible. Moreover, the gross public debt is low at 5.5 percent of GDP and accumulated gross reserves of the public sector amount to over 10 percent of GDP. Practical preparations for the currency changeover are also well underway. Looking ahead, the recent surge in the headline inflation rate is the biggest challenge, as the relatively higher share of energy and liquid fuel in the Estonian consumer basket (adding up to over 20 percent) makes the CPI inflation sensitive to changes in the world market conditions. However, it is reassuring that the core inflation has remained stable at around 2 percent year-on-year.

Macroeconomic policies in 2005

The authorities remain committed to the transparent macroeconomic framework to support sustained economic expansion and smooth entry into the Euro Area. Their policies remain firmly centered around the currency board framework, underpinned by the general government's fiscal position being balanced or in surplus, the strong financial system and labor and product market flexibility. The authorities recognize that the current combination of high output growth and low interest rates leaves no room for complacency to maintain stable and balanced economic development; the sustainability of the external position remains a key issue. While the underlying inflation rate is ultimately driven by external factors in a small and very open economy with the currency board arrangement, the authorities make every effort to ensure stability of the price level and to avoid excessive real exchange rate appreciation.

Fiscal policy

Fiscal policy has a key role for the economy functioning under a currency board arrangement. The authorities have a well established track record of fiscal prudence and the general government is running a surplus budget for the fifth consecutive year. At this stage, the official estimates put the general government surplus for 2005 to over 1 percent of GDP, mostly due to higher than expected output growth and continuous improvements in tax collection, while even higher outcome could not be ruled out. With traditionally conservative growth estimates, the government is planning a balanced budget from 2006 onwards.

The authorities' medium-term budgeting process relies on the State Budget Strategy; in addition, the annual budgeting process takes into account the medium-term impact of next year's budget decisions. The authorities share staff's view of the importance of medium-term budgeting in order to maintain fiscal prudence and to improve expenditure control.

Financial sector policies

The sixteen months of participation in the ERM II mechanism have been uneventful. The Estonian kroon has not experienced any pressures and the short-term interest rate differential against the euro has been negligible at 10-15 bps. Estonia will maintain its currency board arrangement as a unilateral commitment while in the ERM II.

The still rapid credit growth underlines the need to ensure the credibility of the financial system and to avoid possible unwarranted macroeconomic impact if the credit market conditions start to change. As the staff's report notes, the banking sector remains financially sound in every aspect, with profitability solid, the share of nonperforming loans negligible and consolidated capital adequacy ratio at 12 percent, comfortably above the legal minimum requirement of 10 percent. Both the Financial Supervisory Authority (FSA) and banks are performing periodic, forward-looking stress tests of the balance sheets, which have confirmed the soundness of the banking system.

The authorities are monitoring the situation very carefully and stand ready to implement necessary measures, should the credit standards show any signs of worsening. However, with Estonia's banks being fully integrated with Nordic financial groups in both financial and institutional terms and in the context of EU's single market for financial services, the authorities' very close cooperation with financial supervisors of the region is equally important. Maintaining prudent lending policies is also instrumental to contain the increasing gross indebtedness of Estonia's private sector even if Estonia's net position vis-à-vis the rest of the world is not yet alarmingly high.

Structural policies

Estonian business climate remains attractive by international standards with the World Bank's recent survey "Doing Business 2005" ranking Estonia as 16th by ease of doing business. It is, therefore, not surprising that Estonia continues to enjoy sizable gross FDI inflows that reached new highs at around 12 percent of GDP in the first half of 2005 (excluding a major investment in financial sector that amounted to over 20 percent of GDP). The productivity growth has increased further, reaching 6.8 percent in the first half of 2005. Recent developments on the labor market are encouraging with unemployment falling from the peak of 13.6 percent in 2000 to 9.7 percent in 2004 and 8.1 percent in the second quarter of 2005. The number of people unemployed for a year or longer has also fallen to the lowest level of the past six years. While the EU membership appears to have had a significant impact on labor market developments in certain sectors, most notably in the health care and construction, the Estonian authorities agree with staff's advice regarding the wage developments.

Estonia firmly supports the Lisbon goals of higher growth and employment. In October 2005, the Government approved the National Action Plan, focusing on measures to sustain macroeconomic stability and increase competitiveness, including higher investments into R&D, active labor market policies and measures to improve business climate and entrepreneurship.

The authorities continue their advanced reform agenda in the network industries where market liberalization in several sectors, including in the telecom sector, was already accomplished some years ago. In accordance with the EU directives and provisions governing Estonia's accession to the EU, the electricity market will be fully opened for competition by 2012. The market for natural gas is already liberalized to a large extent; the draft legislation is currently discussed in the Parliament to effectively increase the openness of the market for natural gas from 90 to 95 percent.