Eesti Pank - Bank of Estonia

An overheated economy, coupled with delayed euro adoption and economic and political tensions in the region, has raised uncertainty about economic prospects. The authorities need to lock in more realistic expectations and contain current risks by keeping the fiscal position tight and reinforcing prudential policies. Sustaining medium-term growth will require continued efforts to enhance the economy’s flexibility.

Estonia’s enviable economic performance has been supported by prudent macroeconomic policies and increasing regional integration. A solid currency board arrangement, a string of fiscal surpluses, and an open and liberal economic environment have been the basis for the most rapid convergence among new member states.

The resilience of the economy is being tested by burgeoning domestic demand and increased external risks. Rising incomes, ebullient expectations, and the availability of low-cost finance pushed domestic demand well above sustainable levels in 2006, fueling inflation and widening the external current account deficit. Real GDP growth accelerated to 11.4 percent, and unemployment fell below 6 percent for the first time in fifteen years. Wage growth accelerated, fueling concerns about competitiveness. Meanwhile, the delay in euro adoption and, more recently, exchange rate pressures in Latvia and political tensions with Russia have made the external environment less favorable.

Growth is expected to remain above potential in 2007 despite signs that demand pressures may ease. High frequency data indicate that domestic demand was still strong in the early months of the year, and substantial increases in public sector wages could lead to further demand pressures. But leading indicators suggest that a slowdown could be on the way: the housing market has cooled and banks are tightening lending conditions. More broadly, there seems to be increasing recognition that recent trends are unsustainable in the face of capacity constraints and rising costs. For the year as a whole, we project that GDP growth will decline to about 9 percent as supply constraints bind, and that demand growth will slow but will still be strong enough to drive inflation to 5½ percent and widen the current account deficit. In the medium term, these imbalances should unwind and growth should slow towards its potential if the deceleration of demand takes root. However, there is a risk that a delayed adjustment will result in a sharper and more protracted slowdown. Therefore, strong policies are needed to help ease the adjustment to more sustainable growth rates.

Most important is to lock in a tight fiscal stance. The large fiscal surplus in 2006 was a welcome confirmation of the authorities’ commitment to fiscal prudence and appropriately countercyclical given the demand boom. This strong fiscal performance needs to be sustained. It is needed to help contain demand pressures and dampen unrealistic expectations about income growth, thus increasing the likelihood of a soft landing. Given the more uncertain external environment and the postponement of euro adoption, it is also needed to signal the authorities’ sustained commitment to fiscal responsibility—buttressing the currency board arrangement. And it would help create fiscal space for rising future expenditure on pensions and health care as the population ages.

The 2007 budget was a step in the right direction but falls short of this objective. This was the first surplus budget to be presented to parliament, setting an important precedent. But it programmed a large increase in current expenditure (12 percent in real terms), which is excessive in the present environment. The Ministry of Finance currently projects a surplus smaller than what was achieved in 2006, implying an undesirable fiscal stimulus. At a minimum, the authorities should refrain from introducing unbudgeted expenditures and save any revenue overperformance for the year. In particular, a supplementary budget with no additional expenditures would send a needed signal.

Looking ahead, the targeted surplus of 1.5 percent of GDP for 2008-2011 could be more ambitious. Although higher than the surplus budgeted for 2007, this target is not impressive compared to the strong fiscal outturn of 2006. With output projected to be above capacity until 2011, surpluses in the range of 2-3 percent of GDP would be more appropriate. Such surpluses would also help set public finances on a sustainable long-term path to meet the costs associated with population aging. All budgetary initiatives, including pension benefit increases and personal income tax reductions, should be kept within this envelope. If actual growth turns out to be worse (or better) than projected, automatic stabilizers should be allowed to take effect.

We welcome the effort to strengthen the Medium-Term Budgeting Framework (MTBF) by aligning it with the government’s fiscal policies for its expected term of office and using it as a basis for the annual budget process. We urge the authorities to plan expenditure on the basis of conservative growth assumptions and to adhere to the implied expenditure ceilings irrespective of revenue developments. Supplementary budgets that block the effectiveness of automatic stabilizers and undermine the general budget process should be avoided. Also important would be to include in the MTBF an economic classification of expenditure priorities—this would enhance transparency and allow a better understanding of the macroeconomic implications of fiscal policies.

Pressures on the Latvian currency earlier this year put a spotlight on financial vulnerabilities in the region. As in the other Baltic states, the wide current account deficit in Estonia is increasingly perceived as unsustainable. The rapid growth of real estate credit in the context of a strong property boom and intense bank competition creates both financial and macroeconomic risks since borrowers as well as banks may have overestimated the capacity to repay in less benign circumstances.

But the financial sector remains strong. Banks are profitable and well capitalized—with solvency ratios above an already high regulatory minimum—and nonperforming loans are very low. The authorities have increased risk buffers by raising the risk-weighting for residential mortgages, as well as reserve requirements. In addition, banks’ tight integration with larger parent institutions allows for risk diversification at the group level. More recently, market discipline has led banks to tighten credit standards. Nevertheless, credit growth and the associated risks remain high.

The authorities should maintain their proactive approach in raising the awareness of risks and pursuing close cooperation with partner institutions. Both Eesti Pank (EP) and the Financial Supervision Authority (FSA) have become increasingly engaged in making the private sector, including parent banks abroad, alive to the risks associated with rapid credit growth—initiatives that we strongly support. The ongoing efforts to establish domestic as well as cross-border arrangements for supervision and crisis management should continue. In particular, we welcome the recently concluded agreement between the Swedish and Baltic central banks; the recent crisis management agreement among EP, the FSA, and the Ministry of Finance; recent and planned multi-party crisis simulation exercises; and the FSA’s proposal to its Swedish counterpart to conduct joint onsite inspections.

Sustained close supervision of banks’ risk management practices and active use of scenario analysis and stress testing are needed to help assess the adequacy of the banking sector’s risk buffers. Continuing credit growth underscores the need to maintain careful supervision of banks’ credit standards, internal controls, and risk assessment methods. The FSA should conduct macroeconomic stress tests with the support of EP and jointly with the large banks, in addition to the sensitivity analyses it already does. Stress tests based on macroeconomic scenarios will be useful for quantifying the impact of macro-financial vulnerabilities and formulating policies to mitigate them. Results from the banks’ own stress tests could be used as inputs to the macroeconomic stress testing exercise—or at least to cross-check the banks’ calculations. The exercise could also be improved by collecting additional information on borrowers’ capacity to repay.

The authorities need to reassure markets about their commitment to euro adoption. Inflation, pushed up by convergence-related and cyclical factors, is likely to remain above the Maastricht limit for the rest of this decade. Given the delay, we support the recent decision to advance planned excise tax increases to early 2008. This will ensure that the inflationary impact of these taxes will be over by the time Estonia’s inflation rate declines to within reach of the Maastricht criterion.

Over the medium term, labor and product market flexibility will be essential. Such flexibility will facilitate a shift of resources towards the more productive and export-oriented sectors. This will be needed to sustain rapid growth in the face of a declining labor supply and enable Estonia to service its large external liabilities. In this regard, we support the proposal to simplify the administrative procedures for hiring skilled workers from non-EU countries. We also welcome the initiative to review the existing Employment Contracts Act of 1992 to ensure that it remains relevant under present conditions and maintains the desired balance between flexibility and social objectives.

Estonia - 2007 Article IV Consultation