The Economy in Pictures- Estonia

Recent Economic Developments- Estonia from the IMF

Background: Overheating is Estonia’s main near-term challenge. Surging domestic demand has widened the external current account deficit and pushed the economy against capacity constraints. Wage increases have begun to erode competitiveness and kept inflation above the Maastricht threshold for euro adoption. There are signs of an incipient slowdown but a resurgence of demand and an eventual hard landing, with growth stagnating, cannot be ruled out. A strong fiscal stance is therefore needed to subdue wage and income expectations, improve the odds of a soft landing, and reassure markets about the continued commitment to euro adoption. It would also position the budget for future age-related costs. Other concerns are banking sector risk stemming from years of rapid credit growth and a less benign external environment in the face of increased regional uncertainties.

Authorities’ views and policies: The authorities are concerned about overheating and have responded by moving from a fiscal framework based on balanced budgets to one based on small surpluses. They have also reaffirmed their commitment to euro adoption and taken steps to increase the odds of meeting the Maastricht inflation criterion by 2010, the earliest they consider feasible. On the financial sector, the authorities emphasize that market discipline has started to slow the pace of credit growth. They view the existing prudential requirements as adequate and are focusing their efforts on strengthening cross-border cooperation in bank supervision and crisis management. The authorities view external competitiveness as broadly adequate and remain strongly committed to the currency board arrangement (CBA), in place since 1992.

Staff views: A more assertive fiscal stance is needed. For 2007 this means saving any revenue overperformance and resisting spending pressures. For the next four years it means going beyond the modest surplus floors in the fiscal strategy. The strategy on euro adoption is appropriate. The authorities’ initiatives to raise public awareness of macroeconomic risks appear to have borne fruit and should be continued. In the meantime, while banks’ risk buffers seem reasonably wide, their adequacy should be reviewed regularly by active use of stress testing and sustained monitoring of credit standards, internal controls, and risk assessment procedures. Cross-border cooperation in bank supervision is indispensable; the recent initiatives in this area are welcome. The CBA is robust. While some indicators point to real exchange rate overvaluation, exports remain competitive. Nevertheless, rising cost pressures underscore the need for labor and product market flexibility to ease external adjustment and sustain growth.

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