1. Estonia’s recovery has taken hold and inflation has eased. Supported by euro adoption and prudent macroeconomic policies, growth has returned to a sustainable pace in 2012. Exports have been the main driver of the recovery and have substantially exceeded their pre-crisis levels. Tightening capacity constraints have prompted a strong private investment response. Private consumption has been supported by rising consumer confidence and a strengthening labor market. But it has been held back by high household indebtedness that has stressed household balance sheets. Inflation has declined in line with global fuel and food prices, but remains among the highest in the EU. And while overall and long-term unemployment rates have declined, they remain above their pre-crisis levels.

2. Still, growth in 2013 will likely slow to about 3 percent. Gains in domestic demand will be more than offset by weaker external environment. Conditional on a recovery in the euro area in the second half of 2013, exports would continue to provide a positive contribution to growth. Private consumption is projected to expand, bolstered by continued improvements in the labor market and tax cuts. Prospects for investment will be supported by public capital spending. Inflation is projected to moderate to slightly above 3 percent, as declining external price pressures will more than offset the impact of Estonia’s energy market liberalization and increases in excise taxes. Core inflation is projected to remain broadly unchanged at about 2 percent, with productivity gains largely offsetting wage increases.

3. Risks to the outlook for 2013 will largely be on the downside. The risks stem primarily from a prolonged period of slow growth in the euro area. With two-thirds of Estonia’s exports going to the EU, delays in the euro area recovery could slow exports, weaken the labor market, reduce household’s ability to service their loans, and potentially hurt the quality of bank assets. The unwinding of past real and financial sector imbalances would be more protracted and weigh on domestic demand. Financial spillovers could emerge in the event of a sharp resurgence of global financial market volatility. Alternatively, faster-than-expected euro area recovery or unexpected export resilience would boost growth. In this case, continued labor market strength could fuel wage and price pressures.

4. Against this backdrop, macroeconomic policies should focus on underpinning Estonia’s hard-earned fiscal and financial stability as well as safeguarding competitiveness to support growth and employment. The authorities’ policies and successful euro adoption have contributed to reducing Estonia’s imbalances and vulnerabilities. Building on these achievements will entail policies to enshrine fiscal stability, advance financial sector robustness, and broaden sustainable growth.

Enshrining Fiscal Stability

5. The 2013 budget’s spending priorities and cuts in the unemployment contributions rates are welcome. Budgetary spending increases are concentrated on social spending, notably old-age pensions, unemployment benefits, means-tested child allowances, and the wage bill (following a 3-year wage bill freeze). The budget also provides an increase in public investment associated with EU structural funds. Spending increases are partially offset by reductions in current spending. On the revenue side, cuts in the unemployment insurance contribution rates can help household balance sheets. The mission estimates that a small fiscal surplus could emerge in 2013, as the carry-over effects from strong activity in the second half of 2012 will result in slightly higher than budgeted revenues.

6. To avoid untimely fiscal stimulus, determined efforts will be nonetheless needed to resist calls on the public purse in 2013. The mission estimates that the fiscal stance will be broadly neutral and appropriate given cyclical conditions. In this context, the authorities are advised to withstand spending pressures, adhere to budgetary allocations, and save any potential windfall revenues. However, if downside risks materialize, automatic stabilizers should be allowed to operate while maintaining fiscal credibility.

7. With the authorities’ medium target (a small surplus) in sight, Estonia faces the challenge of safeguarding this achievement while addressing medium-term needs. With unwavering efforts to control current spending—including continued public wage bill restraint—and redirect spending to public investment, projected revenues could result in small fiscal surpluses in the medium term. This would keep public debt low and sustainable, and safeguard fiscal buffers to cope with economic volatility and downside risks. But there will be a need, as budgetary conditions allow, to make room for addressing medium-term challenges and reducing the tax burden.

8. Implementing a fully fledged medium-term fiscal framework can help assess policy tradeoffs and avoid pro-cyclical policies. The authorities are discussing how best to align Estonia’s fiscal framework with their obligations stemming from the EU’s Fiscal Compact and the Two Pack. Regardless of the specific fiscal rule and institution setup that will be established, the framework should be consistent with Estonia’s fiscal tradition, and thus be transparent and as simple as possible to support fiscal credibility. Multi-year expenditure ceilings should be an integral element of the framework to reduce policy uncertainty and enhance fiscal discipline. Also, the implementation of the framework should avert pro-cyclical fiscal policies while maintaining fiscal credibility.

Advancing Financial Sector Robustness

9. Estonia’s financial sector has continued to strengthen and, while risks remain, these are mitigated by improving balance sheets and prudential positions. Banks have remained profitable, liquid, and well capitalized despite extensive write-offs that have cut in half non-performing loans. In addition, rapidly growing domestic deposits have resulted in a record low loan-to-deposit ratio. Risks on the domestic side stem mostly from variable-interest mortgage loans tied to the six-month Euribor. Externally, a significant share of Estonian banks’ funding consists of foreign financing, which could be potentially volatile. Risks nonetheless appear manageable. At present, markets expect interest rates to remain low, while improved corporate and household debt-equity ratios and a strong labor market have raised the private sector’s capacity to service its debt. Finally, parent-banks’ funding of Estonian subsidiaries reflects a strategic commitment to highly profitable investments.

10. Macro-prudential policies can help further reduce risks. In tandem with parent supervisors and following relevant EU-level regulations, the timely adoption of the capital and liquidity provisions of the Capital Requirement Directive IV would enhance Estonia’s financial sector resilience. This would not unduly constrain banks’ margins or credit to the economy since Estonian banks already meet or exceed the likely requirements. In view of the prevalence of short-term variable interest rate-linked mortgages, the authorities should also consider introducing ceilings on loan-to-value and loan-to-income ratios to reduce exposure to housing market developments and downside risks. Regarding the institutional structure, the central bank’s macro-prudential authority and existing tri-party (Eesti Pank, MoF, and FSA) forums can be further clarified and strengthened—in line with the European Systemic Risk Board’s recommendations—to advance the monitoring of systemic risks and limit potential fallout.

11. Deeper cross-border prudential arrangements can also enhance financial stability in Estonia. Over the years, Estonia and other Baltic nations have, together with their Nordic counterparts, developed an effective regional supervision framework underpinned by cooperation agreements and the establishment of the Nordic-Baltic Stability Group and Macroprudential Forum. Ongoing work has appropriately focused on establishing a burden-sharing mechanism and a common database for financial groups, as well as on preparing for cross-border crises simulations. In conjunction with EU-level initiatives, these efforts should move ahead by implementing key elements of the framework, notably by defining criteria for burden sharing.

12. The EU banking union would further Estonia’s financial stability in coordination with long-standing close Nordic-Baltic cooperation arrangements. The banking union can bolster financial soundness throughout the EU. In this regard, progress has been made in establishing a single supervisory mechanism (SSM), which will place Estonia’s two largest banks under the direct supervision of the ECB. Additional efforts are however needed to clarify the role and powers of the Estonian authorities in this context, including in supervisory colleges and with regards to the exchange of confidential information. As the SSM and other elements of the banking union go forward, particular attention will be needed to avoid disrupting existing Nordic-Baltic supervisory arrangements.

Broadening Sustainable Growth

13. Estonia needs also to safeguard its external competitiveness, address skill mismatches, and accelerate human capital accumulation. Increasing employment in export-related activities has supported the reallocation of resources to the tradable sector and sharply reduced unemployment. But the latter remains high and further reductions are hindered by skill mismatches and long-term structural unemployment. In addition, while the economy has remained broadly competitive, Estonia faces increasing competition from low-cost producers. As highlighted in “Estonia’s 2020 Competitiveness Strategy,” knowledge-based activities will hold the key to move up the export value chain. In this regard, the mission welcomes the authorities’ ongoing efforts to reform and make training and education programs more flexible, as well as to improve coordination among the relevant institutions. Continued attention to these areas can support human capital accumulation, bolster productivity, and increase long-term growth prospects.


The mission thanks the authorities for their open and fruitful discussions and hospitality.