Washington, D.C., 23 May 2023
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.
Tallinn, Estonia: Russia’s invasion of Ukraine triggered a large rise in inflation, supply chain disruptions, and slower growth in key trading partners. These developments, combined with budget under-execution in 2022, led to stagflationary conditions. Lower energy and commodity prices, along with gradually stronger external demand, are expected to support the recovery. A very large fiscal impulse in 2023 is expected to boost growth in the near term but will also leave inflation well above the euro area average. In turn, high inflation is likely to exert pressure on wages which, combined with declining productivity growth, may further erode Estonia’s competitiveness over time.
A neutral or—at most—an only slightly expansionary fiscal stance in 2023 is needed to help reduce inflation. Together with targeted financial policies to underpin financial stability and structural reforms to address labor market shortages, raise productivity and promote the digital and green transition, this policy mix will help Estonia achieve sustainable and inclusive growth over the longer term.
Context and Recent Developments
1. A war-driven supply shock and demand factors have pushed the economy into stagflation. After a swift post-pandemic rebound in 2021, the war triggered a large rise in inflation, supply chain disruptions, and slower growth in key trading partners. These developments, combined with budget under-execution, have led to a sharp and broad-based economic downturn. Exports have been the main driver, reflecting weaker external demand, but private consumption has also weakened considerably as high inflation has weighed on real disposable income. Despite the contraction in output, the labor market has remained tight, reflecting returning demand from contact-intensive services, while labor shortages persist in the ICT sector.
2. Inflation remains high. Energy prices declined, but, at 13.2 percent in April, inflation remains among the highest in the euro area. Over time, inflation has become increasingly broad-based, with core inflation also rising rapidly, despite the widening negative output gap.
Outlook and Risks
3. During 2023, growth is expected to recover, driven by consumption and exports. The economy is expected to improve sequentially in the second half of the year, but the earlier weakness translates into a projected negative annual growth rate of -1.2 percent for 2023. A better outlook for real disposable income, reflecting sustained nominal wage growth and gradually receding inflationary pressures, along with stronger external demand, is set to support the recovery. The large, mostly permanent increase in discretionary spending is expected to generate a significant fiscal impulse of almost 3 percent of GDP, providing a lift for growth, but also working at cross-purposes with monetary policy and countering the effect of higher interest rates on inflation.
4. Disinflation is expected to be only gradual. Inflation will likely extend its declining trend to an average of 9.7 percent in 2023, driven by lower energy and commodity prices. However, core inflation is expected to remain stubbornly high reflecting second round effects and the stimulative fiscal policy. While compensation per employee has declined in real terms, tight labor market conditions and large adjustments in minimum and public sector wages may exert broader pressures on wages going forward. A concurrent decline in labor productivity may compound the impact on unit labor cost, especially for services providers, where wages are a sizable input cost.
5. Over the medium term, the economic shocks triggered by the war may leave scarring effects. Despite higher interest rates, monetary policy is expected to remain looser-than-warranted by developments in the Estonian economy, while the expected fiscal consolidation in the medium term is only modest. This loose policy mix is expected to leave inflation at more than 3 percent on average in 2025, well above the euro area, and may further erode Estonia’s competitiveness over time. While the economy managed to recover swiftly from the pandemic, under staff’s baseline the war shock is expected to leave a more permanent scar, with growth failing to return to its pre-crisis trend, absent a decisive re-calibration from current spending to productivity-enhancing capital spending and proactive structural reforms.
6. This baseline is highly uncertain, with risks skewed to the downside. An escalation of geopolitical tensions in the region may weigh on the outlook. On the domestic front, fiscal deterioration might become entrenched, above and beyond what is already assumed under the baseline. While supporting near-term growth, an excessively loose fiscal policy would undermine Estonia’s disinflationary efforts and further weigh on its medium-term competitiveness prospects. Tighter labor market conditions, rapid wage growth triggered by generous public sector pay rises and waning productivity may exacerbate these adverse dynamics.
Re-Calibrating Estonia’s Policy Mix
7. The policy mix needs to be re-calibrated to support a more sustainable recovery. Estonia has made remarkable progress over the past two decades, but signs of potential pressures on competitiveness have emerged. Against the backdrop of a structural deceleration in manufacturing productivity, exacerbated by a war-driven supply shock, expansionary policy settings could lead to price and wage pressures and further erode Estonia’s competitive position. In contrast, a much less stimulative fiscal policy should be considered. Alongside targeted financial policies to underpin financial stability and structural reforms to address labor market shortages, raise productivity and promote the green and digital transition, this policy mix will help Estonia achieve sustainable and inclusive growth over the longer term.
Fiscal Policy— Pursuing a Neutral Fiscal Stance to Support Disinflation and Competitiveness
8. A neutral or—at most—an only slightly expansionary fiscal stance is needed for 2023 to help contain inflation. The 2023 budget envisions extensive and mostly permanent measures to address the cost-of-living crisis and rising security challenges. At a projected 4.8 percent of GDP, staff expect the deficit to be about one percentage point wider than planned in the budget, reflecting a combination of additional pressures on public sector wages, automatic stabilizers and, to a lesser extent, revenue shortfalls. In contrast, a neutral fiscal stance—in other words an unchanged structural balance—would contribute to reducing the risk of inflation becoming entrenched and the resulting threat to long-term competitiveness. This excludes the planned increase in defense spending, which is expected to have limited domestic impact.
9. Several options to reduce the fiscal impulse in 2023 should be explored, while retaining targeted support to the most vulnerable. As energy prices recede, consideration should be given to phase out the most recent increases in family allowances. Containing the expansion of public sector wages is critical. This includes keeping the wage bill below the average share in GDP observed during 2020-22 and limiting the flexibility of line ministries and local authorities to raise wages. Re-calibrating current spending towards productivity-enhancing capital spending would also be important to safeguard competitiveness. Finally, the case for bringing forward some of the tax hikes currently envisaged from 2024 should be explored. A car tax should be introduced promptly. The revision of land tax values, last modified in 2001, should be implemented. The land tax exemption for primary residences and the 10 percent cap on increases should be abolished.
10. Over the medium-term, fiscal policy should preserve Estonia’s buffers to counter future shocks and spending pressures. Under the baseline, the structural deficit improves by only one percentage point over 2024-2028 to a deficit of around 2 ½ percent of GDP. In contrast, staff’s recommended fiscal path entails reaching a balanced structural budget over the forecast horizon through an improvement of about ½ percentage point of GDP a year, anchored in the national fiscal rule. This path requires additional fiscal consolidation measures including means testing for social programs and savings on government operational expenditures. A more efficient execution of capital expenditure by reviewing project appraisal procedures, while prioritizing productivity-enhancing investment, including those promoting the green and digital transition, would also be critical. The recent changes in the pension system, which has made contributions to the second pillar voluntary and has led to large withdrawals, will likely result in spending pressures in the long run due to insufficient benefits from the first pillar, further reinforcing the need of preserving fiscal buffers.
11. Ongoing efforts for upgrading fiscal management and institutional capacity are important. Staff welcome the recent efforts to strengthen transparency and fiscal risk management, including the publication of Estonia’s first Fiscal Risk Report. Further progress in enhancing long-term planning, project appraisal and execution, in line with the IMF Public Investment Management Assessment would help improve the absorption of the EU Funds and support Estonia’s digital advantage, green transition, and social resilience.
Financial Policies—Preserving Financial Stability amid Rising Interest Rates
12. Bank solvency and liquidity risks appear limited so far. Capital ratios are above regulatory requirements, especially for systemically important banks. NPL ratios are low, and have continued declining, despite weaker economic conditions. Banks’ holdings of securities are relatively small, even compared to other Baltic countries, limiting the risk of (realized or unrealized) losses as interest rates increase. While reliance on wholesale funding is elevated for some banks, systemic liquidity remains ample. Tighter monetary policy is feeding through higher bank lending rates, which have boosted bank profits but have also affected the ease of Estonian households and companies to service their (mostly floating rate) debt and access new credit. Over time, this may weaken banks’ asset quality as well as solvency and liquidity positions.
13. Close vigilance is warranted. Comprehensive and frequent bank portfolio reviews should be accompanied by rigorous stress tests, including to assess risks stemming from wholesale deposits, funding through internet platforms, cross-border lending, and broader spillover effects from real estate markets in the region. Less-significant institutions, which have more limited buffers, should be closely monitored to ensure they remain well capitalized. Cyber risk should continue to be integrated in vulnerability assessments and contingency plans.
14. Macroprudential policies should remain agile in response to rapidly evolving circumstances. Earlier tightening of countercyclical buffers was appropriate, given the need to preserve robust buffers against sustained increase in credit and house prices. Policies, however, should be ready to respond to credit supply disruptions. In an adverse scenario characterized by a further tightening in global and regional financial conditions, intensified financial instability, and heavy loan losses, including on the back of an abrupt house price correction, a relaxation of the countercyclical capital buffer should be considered to allow adequate provision of credit.
15. Building on recent progress, systems should be further enhanced to address Money Laundering / Terrorist Financing (ML/TF) risks. Staff welcome ongoing efforts to enhance the supervisory capacity of the Financial Supervision and Resolution Authority and the Financial Intelligence Unit. In response to a recent MONEYVAL assessment, which found Estonia’s Anti-Money Laundering / Combating the Financing of Terrorism (AML/CFT) systems in need of further improvement, priority should be given to mitigating cross-border ML/TF risks from higher-risk countries with material financial flows, further enhancing ML/TF risk assessments, and improving risk-based supervision of banks and virtual asset service providers. The legislation on crypto assets should be finalized given elevated risks stemming from the fintech sector.
Structural Reforms —Promoting Inclusive and Sustainable Growth
16. Higher investment in R&D and innovation would enhance Estonia’s digital transition. ICT services have expanded rapidly in recent years, while the use of digital processes in traditional sectors, including in construction, has also grown. Increasing the share of private sector R&D to a level closer to the EU average, including through increased collaboration between universities and businesses, would help accelerate the country’s evolution towards higher value-added production and exports. Further strengthening connectivity, SME adoption of digital technologies, and capital market deepening would also benefit productivity.
17. Addressing labor market shortages and closing skill gaps is instrumental in strengthening long-term growth prospects. Despite the current economic slowdown, labor market conditions remain tight. Shortage of skilled labor is particularly acute in the ICT sector, a potential hindrance to digital transformation. The authorities should further build on their ongoing efforts to close existing skill gaps and limit skill downgrading of refugees through active labor market policies. In the short term, greater reliance on flexible and part-time work arrangements would enhance labor participation. In the longer term, policies aimed at enhancing education in technical and digital skills and offering vocational training would facilitate job mobility and boost employment among low-skilled, young, and older workers.
18. The targeting of social welfare measures should be reviewed. After improving in 2021, social indicators have deteriorated in 2022, reflecting the cost-of-living crisis, particularly among the elderly, people with disabilities, women, and the unemployed. Recent social welfare reforms, including those related to subsistence benefits and unemployment insurance should be reviewed to ensure effectiveness, appropriate targeting, and adequate value for money. Progress toward reducing the gender pay gap, which stands out in the EU, should be enhanced alongside efforts to address gender bias in education and the labor market, as well as the high motherhood penalty.
19. Estonia’s energy security could be supported by a more ambitious green transition. Energy security was strengthened and diversified by filling gas reserves, securing sources of LNG supply, and building infrastructures. However, Greenhouse Gas (GHG) emissions have likely increased in 2022 due to a higher reliance on oil shale for electricity production following the energy crisis. Phasing out oil shale in energy production, introducing a carbon tax, and extending the coverage of the Emissions Trading System, currently the lowest in the EU, are key steps to reducing GHG emissions. Accelerating the planned investment in renewables, especially in wind and solar energy, which are a relatively small share in Estonia’s energy mix, and boosting energy efficiency in the building and transport sectors are also priorities.
The mission would like to thank the Estonian authorities for their warm hospitality, close collaboration, and insightful discussions.
Source – IMF