Moreover, despite enduring one of the sharpest contractions in the EU in 2009, the authorities commendably persevered with policies based on satisfying the Maastricht criteria. With the fiscal deficit remaining comfortably below the Maastricht ceiling in 2010, Estonia has earned the distinction of being one of only two EU countries not currently under an Excessive Deficit Procedure.
An ongoing export-led recovery is poised to strengthen, amid inflation surprises. Mirroring near-term developments in trading partners, exports are expected to continue boosting activity in 2011. Still, growth will remain below the boom-year average, with domestic demand burdened by high household debt, slow real income growth, and double-digit unemployment. Reductions in the latter may likely be hindered by mismatched skills and low labor mobility. Inflation is projected to increase further in 2011 as the full-year impact of global food and fuel prices will be felt even though the impact of administered price increases will wane. Core inflation should remain subdued throughout 2011. While recent wage increases have so far not hurt profitability, they nonetheless warrant close monitoring given losses in price and cost competitiveness in the boom, the slack in the economy, and high unemployment.
Positive surprises to the outlook are possible, but downside risks appear more prevalent at end-2010. Faster growth is feasible if trading partners’ activity proves lasting but this could pose sectoral wage pressures associated with labor market constraints. But the risk of slower growth – including from renewed uncertainty in global financial and sovereign markets and the tail risk of global double-dip recession – has increased. Besides direct trade-related effects, a faltering recovery or if unemployment otherwise becomes entrenched could result in new nonperforming loans (NPLs) weighing on bank’s willingness to lend and support the recovery. Estonia could also be exposed to adverse financial spillover effects if foreign parent banks are hit by tail risks.
Against this backdrop, Estonia faces three main challenges to remain on a sustainable growth path: Safeguarding Fiscal Consolidation and Establishing Counter-Cyclical Policy.
Despite an upcoming election year, the 2011 budget keeps a tight rein on expenditures while targeting investment and education and protecting social spending. The state’s administrative expenditures will be frozen at 2010 levels with roughly unchanged operational expenditures. Still, social protection, including a partial recovery of payments to the pension fund, will account for about 30% of expenditures. A small increase in the 2011 budget deficit reflects the expiration of one-off revenue factors.
Sticking to the 2011 general government deficit target will be critical for Estonia’s fiscal discipline. This would reaffirm the authorities’ commitment to prudent macroeconomic management, and achieving their target will further enhance credibility during Estonia’s first year in the euro area. Still, should downside risks materialise, its low public debt and fiscal buffers provide space for automatic stabilizers to operate up to the Maastricht limit. Should revenues surprise on the upside, strict adherence to spending limits will be essential to avert pro-cyclical fiscal policies observed in the boom.
Looking forward, the authorities’ medium-term goal of restoring a balanced budget provides a natural benchmark for fiscal policy. Besides being consistent with EU obligations and ensuring fiscal sustainability, the authorities’ medium-term goal would safeguard fiscal buffers – which have played a critical role in negotiating the global financial crisis – needed to bolster Estonia’s capacity to cope with shocks.
Joining the euro system will further lessen financial sector risks, but elevated global financial market tensions and the legacy of the domestic credit bust call for ongoing vigilance. This will require ensuring that:
• the necessary liquidity and collateral systems and procedures are operational so that all banks have effective access to available liquidity facilities from 1 January 2011. Preparations by the Bank of Estonia and major banks are well advanced, but all banks should be encouraged to be fully prepared.
• in collaboration with home supervisors, bank’s contingency plans remain effective as lower reserve requirements reduce available buffers and Nordic countries phase out public guarantees in 2011. Parent banks are among those with the largest maturity mismatches and wholesale funding dependency;
• provisioning and capitalisation remain ample in light of ongoing rescheduling of loans, a fairly illiquid property market, a large share of mortgages in negative equity, and high household debt. The authorities are encouraged to continue making use of stress tests to identify vulnerabilities.
Fully Deploying Potential Resources and Restoring Competitiveness
Harnessing Estonia’s potential requires employing all its resources and continued increases in productivity and competitiveness. From a cyclical perspective, the previous boom-induced gap between real wages and productivity appears to be narrowing. The longer-term challenges are well addressed in the “Estonia 2020” competitiveness strategy. Besides safeguarding Estonia’s stable macroeconomic and business friendly environment, supported by flexible labor markets, these goals will entail facilitating reallocating resources to the tradable sector. Estonia’s active labor market policies (ALMP) – geared at ensuring that workers acquire the skills demanded by the economy – are key to address the skill mismatch legacy of the construction boom. In this regard, the authorities have increased resources devoted to education and training, including the work practice, pilot voucher, and business start-up schemes. They have also sought to address the schemes’ rigidities. Still, there will be a continuing need to review their effectiveness, exploit programs’ synergies and potential efficiency gains in the provision of ALMP as well as vocational and tertiary education. Furthermore, boosting productivity and competitiveness will require climbing up the technology and quality ladder. In this regard, the authorities have recently increased R&D expenditures and improved access to its financing. Continued use of EU structural funds in support of life-long learning and needed infrastructure improvement can also support sustainable human capital development, increase labor mobility, including geographically, and establish a solid foundation for rising living standards.
With thanks to the IMF. For more information on Estonia, go to http://www.imf.org/external/np/ms/2010/121310.htm