Republic of Estonia: Staff Concluding Statement of the Virtual 2021 Article IV Mission



A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Strong macroeconomic policies and buffers have helped Estonia weather the COVID-19 pandemic. The economy is expected to recover over 2021–22, although there is pronounced uncertainty on both the up and down sides. Policies should seek to continue the effective vaccine rollout and minimize risks of scarring. Fiscal support should be maintained until the recovery is firmly entrenched. Subsequently, priority should be put on policies to reallocate resources toward growth-friendly and productivity enhancing investments, including in digital and green sectors. Though support through bank payments moratoria has expired, targeted financial support should continue to be provided to some sectors. The macroprudential stance is appropriate, but continued surveillance is warranted in the housing market with a view to recalibrating the tools in line with evolving economic and market conditions. Continued monitoring of AML/CFT developments is warranted; ongoing initiatives for further advancing the reform agenda in this area are welcome. 

Economic Situation and Outlook

Estonia has been broadly successful in managing the COVID-19 pandemic, but the second wave has slowed the recovery’s momentum. The lockdown of March 2020 helped contain infections and mitigate negative health outcomes but triggered a deep decline in activity in the second quarter of 2020. The rapid, broad-based, and sizable policy responses and an easing of the restrictions underpinned a strong economic rebound in the second half of the year, and as a result Estonia’s output fall in 2020 was among the mildest in the EU. The second wave of the virus slowed the recovery’s momentum, but more recently relatively strong progress with vaccinations is improving health outcomes and boosting confidence. 

Output is expected to recover in the near term, but unevenly, and the projection is subject to substantial two-way risks. A robust recovery is projected for 2021 and 2022, of 3.4 and 4.5 percent growth respectively on the back of continued progress with vaccinations, ongoing policy support, a boost to domestic demand from the expected withdrawal of pension system savings, and EU fund-backed public investment. Over the medium term, growth would ease closer to 3 percent. Inflation is projected to pick up from the very low levels of 2020 and reach 2½ percent by 2022, before easing to a 2 percent pace in the medium-term. There are large two-way risks, including from virus mutations and economic scarring on the downside, and improved global trade, ramped up vaccinations, and enhanced opportunities for digital and green growth on the upside.     

Fiscal Policy 

Fiscal support, the cornerstone of the crisis response, should be maintained until the economic recovery is firmly entrenched. Supportive financial conditions and the temporary suspension of the EU fiscal rules offer unique policy space to address the crisis. The fiscal support package, augmented through the 2021 supplemental budget, has been sizable (6½ percent of GDP) and its implementation has been well-coordinated. Fiscal support has focused on wage and income transfers, subsidies, and credit facilitation for businesses. As the economy recovers, the support measures should be gradually withdrawn in a coordinated and well-communicated manner, ensuring that the economy is on a sustainable growth path and health conditions improve. Further improving fiscal transparency and project implementation and maximizing the impact of NextGen grant funding should complement the scaling up of public investment, including in the health system.

Staff’s medium-term projections presume the strengthening social safety nets and boosting capital investment. While the impact of the pandemic is easing, it continues to pose a drag on the economy and raise social concerns. Therefore, staff’s forecasts accommodate additional spending for social safety nets. Over the medium term, the significant fiscal space should be used to boost productive investment, both to support the ongoing recovery and to increase potential growth. Current spending is projected to decline owing to the support package’s temporary elements; however, the decline should be gradual, reflecting the need for continued work ability reforms and higher needs for building skills and capacity in the growing digital and green sectors. The scaling up of investment should be underpinned by improved public investment management and enhanced fiscal transparency and governance. While governance procedures are strong, there could be room for further enhancements, drawing on the experience of fiscal support management during the pandemic.     

A robust and well-sequenced plan for gradually rebuilding fiscal buffers and managing debt is also needed. As economic and health conditions improve, a plan to return to the medium-term objective remains appropriate. Revised EU-fiscal rules would be a key anchor for post-pandemic fiscal policy. While the current fiscal stance remains appropriate, in the medium term, Estonia will need to find a credible balance between maintaining fiscal discipline and further increasing productive public spending. High-quality resource-mobilization measures would need to be prepared as part of contingency planning and continued upgrading of public asset and liability management.   

Structural Policies  

Structural policies should aim at containing any potential damage to the productive fabric while fostering resource reallocation. The wage support program is a key element of the authorities’ package and stands out due to its large size, take-up, and ameliorative effects on the labor market. Going forward, comprehensive monitoring of all types of support based on a battery of economic and health indicators should guide decisions on the costs and benefits of different programs and improve their targeting, should there be a case for renewing their use for employment support. To bolster efficient resource allocation, active labor market policies should be ramped up for enhanced education and training to match workers to good jobs and reduce skill shortages, particularly among the young, who were especially affected by the crisis.            

To manage potential social scarring risks, policies should continue to reduce inequality and gender gaps. While Estonia has made welcome progress in reducing overall inequality, remaining pockets among the elderly could have been worsened by the pandemic impact. The recent and planned increases in pension entitlements are welcome, and an updated review of the pension system that is planned for 2022 will help map out options to better calibrate the pension system’s objectives in the context of the second pillar downsizing. Implementation of the authorities’ existing array of gender-based initiatives should be accelerated. Further facilitating immigration could help address the nexus between population aging, low-productivity, and scarcity of skilled labor. 

Structural policies should continue be focused on the green and digital transition. The COVID-19 shock has underscored Estonia’s advantages in digital government services. NGEU funds will open opportunities for further progress in the digitalization agenda. In particular, provision of grants, investment support, and digital skills training could help promote further advances in cybersecurity, broadband corridors, and less-digitized public services. It is also critical to step-up digitalization of private businesses, whose achievements in this area are somewhat less impressive. Drawing on the government’s strong commitment to the climate agenda and recent progress in further limiting GHG emissions, the authorities should continue their efforts to fully achieve international climate mitigation commitments as well as other aspects of their extensive climate agenda. Further steps should be taken to advance the restructuring of the oil-shale sector while duly taking into account related social impacts, including with the resources of the Just Transition Fund. A comprehensive and predictable carbon pricing strategy, some elements of which are currently under consideration for strengthening at the EU level, should be the centerpiece for credibly achieving the emissions targets.  

Financial Sector 

The financial sector is weathering the pandemic well. Estonian non-performing loans have continued to decline through end-2020 despite the expiration of payment moratoria. Household and corporate balance sheets have strengthened, and growing house prices still appear to be aligned with fundamentals. The financial sector provided substantial support to borrowers during the pandemic on account of payment moratoria and regulatory forbearance as well as the use of macro-prudential measures. Although availability of credit is improving, demand for credit has slowed, including among SMEs, which were heavily impacted by COVID-19. Average interest rates fell over the past year, reflecting improved bank competition and easier financial conditions. Addressing remaining bottlenecks to resolving insolvencies could incentivize corporate credit and lower the cost of borrowing.

Financial sector supervision and macroprudential policies are appropriate but continued careful monitoring of developments is warranted. The financial oversight framework has served the banking system well, but in the context of the pandemic impact, further vigilance is needed. Banks’ exposures to pandemic-hit sectors seem to be contained, and banks can now more soundly re-assess their borrowers and step up credit provision to more viable sectors. Given the uneven nature of the recovery, flexible implementation of support to targeted borrowers could still be retained based on clients’ conditions. The macroprudential stance is appropriate, though there is a need for a continued reassessment of the policy tools in light of developments in the real estate markets and the potential impact of the withdrawal of pension savings.

The AML-CFT reform agenda should be further advanced. The authorities have continued to make legislative and institutional progress, including amending the AMLTFP act in line with the EU fifth AML directive and tightening licensing and practices of virtual currency service providers. The evaluation by Moneyval in 2022 and upcoming regional technical assistance present opportunities to assess and showcase progress in the AML/CFT area and advance the reform agenda. As per earlier IMF staff recommendations, thematic and targeted inspections of financial institutions should be continued and the process of imposing fines for AML/CFT violations should be streamlined.       

The mission would like to thank the Estonian authorities for their generous availability and candid discussions.