July 1, 2019

An International Monetary Fund (IMF) staff team, led by Mr. Cheikh Gueye, visited Tallinn during May 21 - 27, 2019 to establish contact with the new administration and to prepare for the next Article IV Consultation mission that is expected to be held in the fall. The mission took stock of the recent economic developments and discussed forward looking plans established by the new administration.

Recent Economic Developments, Outlook, and Risks

Economic activity has been strong, while inflation remains high. Real GDP growth averaged 4.1 percent during 2016–18 (above potential in the last two years) driven by domestic consumption—supported by rising employment and wages—and a pickup in investment. Estimates for industrial production and turnover of retail trade for 2019Q1 point to continued strong activity for the rest of 2019. Reflecting this strong economic activity, inflation remains elevated, reaching 3.2 percent (y/y) in April, underpinned by recovering energy prices, rises in air fares and drought-related increases in food prices.

Despite this rapid output growth, increases in productivity continue to lag those in wages. Gross wages were up by 8.9 percent—driven by a tight labor market—and outpaced productivity growth of 7.8 percent last year, reflecting, among other issues, also relatively low investment in research and innovation. Meanwhile, unit labor costs rose by 9.5 percent, faster than in EU peers, raising concerns about medium-term competitiveness.

Fiscal policy was loose in 2018. The fiscal stance was projected to be close to neutral, but provisional data showed a headline deficit of about 0.5 percent of GDP, and a structural deficit of 1 percent of GDP. The stance was driven by increased salaries for priority occupations including teachers, health, internal security, and cultural workers, higher-than-programed public investments and transfers to households. Revenue growth remained robust, helped by the strong domestic consumption. The public debt stock remains modest at 7.9 percent of GDP in 2018, far below the median of 37 percent of GDP for single A-rated sovereign peers.

The external current account surplus has narrowed . The current account balance declined to a surplus of 1.7 percent of GDP in 2018 from 3.2 percent of GDP in 2017, as the trade deficit widened, reflecting steady growth in domestic demand that outpaced strong export performance. The real effective exchange rate appreciated by 3.6 percent in 2018, partly driven by rising labor costs.

Real estate activity has moderated, but prices continue to rise. Transactions in the housing market slowed by 1.6 percent (y/y) in 2018, compared to an increase of 8.2 percent (y/y) in 2017. House prices, as measured by the real estate index, increased by 5.7 percent but by less than nominal GDP, supported by the low interest rate environment and solid domestic activity, after increasing by 7.7 percent in 2017.

Banking sector soundness indicators remain strong but there are concerns with AML/CFT issues. Estonia’s mostly Nordic-owned banking system remains well capitalized, liquid, and profitable. But AML/CFT-related risks, mostly from the past, are adversely affecting share prices and to a lesser extent funding costs for parent banks. Investigations are being conducted at Swedbank and the license of the Danske bank branch, formerly used for suspicious transactions, has been revoked [1] .

The near-term outlook is favorable. Real GDP growth is projected at 3 percent in 2019, supported by strong domestic demand on the back of a continued tight labor market. Inflation is expected to reach 2.8 percent by end-2019, mainly due to high energy prices and wages that should keep domestic consumption strong in the near term. A less favorable external environment amid stronger domestic demand should lead to the current account narrowing further. However as potential growth is being constrained by weak productivity and adverse demographic trends, growth is projected to ease to 2.8 percent in 2020 and converge to its potential level over the medium term. Inflation could edge down to 2.8 percent in 2020 and slow further subsequently.

Risks to the outlook are tilted to the downside. On the external side, intensification of trade tensions and weaker growth in advanced economies and major trading partners could weigh on investment and exports, adversely impacting growth. Tighter financing conditions in Nordic countries could impact the economy through reduced funding from parent banks. On the domestic front, policy implementation risks are present, including from reforms of the second pillar pension system and constraints to economic immigration. As the economy is in a cyclical upswing, there are risks of overheating and inflationary pressures, with spillovers to competitiveness. Tighter labor market conditions could pile pressure on wages, affecting competitiveness.

Policy Options

Against the backdrop of output that is above potential, real interest rates that are low for the foreseeable future, and weak productivity, fiscal policy is expected to bear the bulk of the load in rebalancing of the policy mix. Structural reforms and macroprudential policies would help enhance productivity and maintain financial stability respectively.

Fiscal Policy: The mission reiterated staff policy advice to move toward a more neutral fiscal stance, while safeguarding spending on potential growth and productivity-enhancing investments including for infrastructure, research and development, innovation, education, health and training.

Fiscal policy has been accommodative with cumulative deficit positions . The structural deficit was estimated at 0.2 percent of GDP in 2017 and 0.8 percent of GDP in 2018. Fiscal deficits of this magnitude exceed the allowable threshold based on previous surpluses of 0.5 percent of GDP. The cumulative impulse, as measured by the sum of the changes in the structural balances, is estimated at about 1.1 percent of GDP during 2017-18.

Under this fiscal position, the new coalition envisages a package of policy measures:

• Reforming the pension system. The administration is exploring ways to increase state pensions and make participation in the second pillar pension voluntary in a phased manner. Individuals could withdraw accumulated funds with an option to place them in a preferred investment account. They could also be allowed to opt out of the second pillar and make payments to the first pillar which would partly finance the planned increase in state pensions. Individuals could otherwise withdraw the balances gradually and spend them. The plans also include a possible reopening of the second pillar to target new entrants. Staff advocated proceeding cautiously, considering pension system sustainability, the fiscal implications, as well as the macroeconomic consequences as the economy is already running over potential and is expected to do well over the medium term .

• Improving investment plans. Under the discussions of the state budget 2020-23, the ruling coalition envisages scaling up public investment. Staff’s view is that while fiscal policy could be helpful in elevating potential growth, scaling up public investment should go together with enhancing the management capacity as strongly advised by the recent PIMA . In that line, the authorities have decided to maintain investment in research and development at 0.7 percent of GDP, however given the need to accelerate productivity growth, staff supports raising it further, at the public and private levels.

• Revising the fiscal rule. The new ruling coalition has agreed to change the fiscal rule that would have forced the government to compensate last years’ deficits by accumulating equivalent surpluses. The new rule would give it room to address the plausible additional spending. Against this backdrop, staff’s view is that it is critical to observe a more neutral fiscal policy stance, with measures reversing in the short term the recent loose fiscal outturn. On the revenue side, s taff supports reducing excise and alcohol tax levels to a reasonable level to mitigate any disruptive impact on taxes of cross border trade. On the spending side, staff welcomes the government plans to review the public investment portfolio based on efficiency, while strongly reiterating the need to defer less critical investment projects and rationalizing current expenditures.

Regarding the second pillar pension reforms, staff have the following concerns:

• While the reform is partially motivated by the low rate of return of the pension scheme, it would still take away some minimum rate of return for individuals who belong to a defined contribution scheme.

• Although the second pillar pension system is in principle a private scheme, there are clear implications for the budget. Furthermore, some of the people who opt out of the second pillar could require in the future public assistance because savings in the first pillar may not be enough.

• Given Estonia’s aging population, the reform in its current form would increase the burden on future generations even more by letting people reduce their pension savings.

  In view of these concerns, staff recommends factoring in the following considerations:

• The proposed measures, if implemented, could generate both short-to-long-term fiscal risks, reduce benefits for future pensioners, and possibly downsize or eliminate the second pillar scheme.

• Cashing out saved balances could boost current consumption, fiscal revenue, and economic growth in the short term but reduce future pension entitlements in the long term. The role of pension scheme managers could become economically unviable due to a significant reduction in participation rates.

• Replacing second pillar schemes with personal pension accounts could expose individuals to investment risks, including higher costs, thereby imposing welfare losses.

  The mission supports that the government conducts an in-depth assessment of the current pension system and only embarks on a new structural pension reform if all other options are exhausted and a broad-based agreement is achieved regarding the policies and technical details of a new pension system policy. In that line, as all stakeholders expressed the need, staff strongly supports a workshop on pensions system reforms to be held very soon given the macro-criticality of the issue.

  Structural Policies

  The mission welcomes progress in policies aimed at boosting productivity but there is scope to implement more reforms. In the context of “Estonia 2020,” structural reforms are focused on aligning the education system outcomes with the skills set needed by the labor market. Reforms are aimed at enhancing vocational training, higher education, and life-long learning. The mission noted progress achieved through these programs, but so far capacity lags labor needs including for upskilling and retooling the workforce. The mission noted the upcoming efforts for more research and development, through more targeted spending.

  Structural reforms have helped boost labor supply but deeper action is needed to address demographic changes . The robust economy, work ability reforms, and positive net migration are helping the labor market. Unemployment rate reached 4.7 percent in 2019Q1, well below the 7.7 percent for the Euro area. But the labor force is projected by the UN population prospects to shrink, which could constrain potential growth and the broader social and economic outlook. Indeed, a rising dependency ratio could reduce output per capita and put pressure on public finances. In this context, the mission commended the authorities for continued efforts to bring back more inactive people into the labor force. The mission also welcomes the government’s support of vocational training, creating more opportunities for people to upgrade their skills. The mission encourages furthering reforms of the active labor market policies, while tackling constraints to economic immigration.

  Addressing inequality, including the gender pay gap, could help to increase economic growth prospects. The mission welcomes recent efforts to address the significant gender pay gap, including the shortening the of maternity leave and increasing the flexibility of parental benefit system, including by higher inclusion of fathers and by possibility to partition the use of parental benefits to three years. But the high gender-pay gap (25.2 percent compared to 16.2 percent for the EU) and relatively weak flexibility of the enrolment in childcare continue preventing the country from realizing the benefits of improved participation of women in the labor force. Though enrolment in childcare is improving, its flexibility falls short in meeting parents’ needs. The mission noted that female participation in the labor market is already high but would benefit even more from more transparency requirements for pay and increased availability of childcare as promoted in the Gender Equality Act. In this regard, the mission welcomes the recent research project aimed at improving gender payroll statistics, understanding of the large unexplained gender pay gap (85 percent cannot be explained by the available data) and providing policy options to reduce this gender pay gap .

  Strengthening the resolution of corporate insolvency could enhance economic resilience. Estonia has one of the best business environments, attracting numerous foreign investors. Marked by lengthy proceedings that trap labor and financial resources in less productive firms and create disincentives for creditors, [2] the current insolvency regime is far behind peers’ in terms of efficiency and predictability. The lack of predictability potentially affects the economy’s reallocation of resources. [3] Sectoral and firm level analyses suggest that capital reallocation tends to be inhibited in countries with lower quality frameworks. Thus, the mission welcomes recent efforts to examine the insolvency framework which would benefit from enhancements of its legislative framework to allow creditors to initiate restructuring, provide options for out of court settlements, and to develop an early warning system to detect signs of distress in companies.

  Financial Sector Policy

  The mission noted the strong FSIs but called for continued collaboration and improved cross-border supervision. FSIs remain solid but the dominance of cross-border parent banks remains a source of vulnerability due to interlinkages and potential spillover effects. Staff welcomes efforts to shore up cross-border supervision including supervisory colleges with Scandinavian supervisors, and greater transparency in cross-border banking activity since October 2018. The mission urges continued efforts to operationalize the memorandum of understanding signed with the Nordic-Baltic Stability Group and enhanced clarity in parent-home supervisory obligations.

  Structural changes at Luminor bank demand supervisory vigilance. The recent merger has expanded the size of the banking sector to 145 percent of GDP from 102 percent, increased banks’ concentration—the three largest banks hold a market share of 85 percent, almost doubled the credit portfolio (accounting for branches in Latvia and Lithuania), and contributed to a one-off slight deterioration in asset quality, on a consolidated basis—although NPLs remain very low. The merger necessitates monitoring risks and considering developments in Latvia and Lithuania in the calibration of macroprudential policies.

  Strengthening the AML/CFT framework remains a priority. The mission welcomes the implementation of AML/CFT risk-based supervision of financial institutions and efforts aimed at deepening regional cooperation regarding AML/CFT supervision of cross-border banking activity and promoting domestic coordination among competent authorities. The mission notes that discussions among government officials regarding legislative initiatives to amend the AML/CFT framework—including to increase the maximum amount of fines for breaches of compliance with AML/CFT requirements and to reform and simplify the procedure for their application—are on-going. Fund staff intends to incorporate an AML/CFT component into the Article IV consultation with the Republic of Estonia in 2019.

  The authorities should continue monitoring carefully macro-financial developments, and policy action should be taken if needed. Staff welcomes the range of measures in place to forestall risk-taking by banks and to tackle any potential imbalances in the real estate sector. These measures are helping to build resilience by providing cushions against unexpected deterioration in the economic environment and increasing vulnerabilities. The mission supports that the level of the countercyclical capital buffer (CCyB) remain set at zero, owing to the stable household debt, slow credit growth, and a forecast of moderating corporate debt due to weak investments. Consequently, the mission concurs with the authorities to use a more targeted tool and introduce a risk weighted floor of 15 percent for housing loans to mitigate risks from high exposure. Staff will continue its assessment of the macroprudential stance during the article IV consultations.

  The mission team held fruitful discussions with the prime minister of Estonia Jüri Ratas, the Eesti Pank Governor Ardo Hansson and incoming Governor Madis Müller, Minister of Finance Martin Helme, and other senior officials. The mission also held discussions with members of the Finance and Budget Committee of parliament and representatives of the financial sector.

  The mission would like to thank the Estonian authorities for their availability and cooperation as well as for the arrangements made to facilitate the mission’s work in Tallinn.