November 4, 2019

Growth is slowing but overall economic performance remains strong, which is benefiting the public finances, as well. With the economy operating above its potential, the positive fiscal impulse should be unwound. Over the medium term, however, Estonia could use the substantial fiscal space to support productivity-enhancing investments and structural reforms to enable the economy to grow rapidly in the future. The work ability reform and the active labor market policies have been successful in increasing labor force participation, but raising potential growth requires higher productivity, especially given demographic trends. The macroprudential framework is strong, but macro-financial developments need continued careful monitoring and the AML/CFT framework and cross-border supervision have room for enhancements.

Economic Situation and Outlook

Economic growth remains strong but is expected to slow. Real GDP growth is projected to reach 3.2 percent in 2019, from 4.8 percent last year, supported by still-strong domestic private consumption. Slowing economic activity reflects weak external demand and a significant slowdown in the construction sector. Inflation has decelerated due to lower energy prices. The solid performance reflects an accommodative fiscal policy stance and a monetary policy environment that is expansionary for Estonia. Unemployment has reached a record low, while labor market reforms and strong wage growth have led to increased labor force participation. Household debt, though elevated, remains stable. Net public debt is negative while the current account is still in surplus.

The outlook remains favorable, but with downside risks. Strong private consumption on the back of a tight labor market is expected to continue shoring up growth in the near term. Over the medium term, real GDP growth is projected to converge to its potential; potential growth, however, will be constrained by the level of productivity over the medium term and demographic trends in the long term. Inflation, though receding, is projected to remain above the Euro Area average. Externally, a materialization of trade risks could weaken growth and slow export in Nordic countries, which would weigh on domestic investment and lead to tighter financial conditions. Tighter financial conditions in Nordic countries could also impact liquidity and funding for Estonia’s banking system. Domestically, labor shortages in the highly-skilled segment and continued wage pressures could affect medium-term competitiveness. Ongoing AML/CFT concerns could be source of further reputational risks.  

Policy Discussions

Policies should seek to raise productivity, while addressing external imbalances. Over the near term, with a positive output gap there is a strong case for unwinding the current expansionary fiscal stance. However, Estonia has the scope to reorient fiscal policy in a more growth friendly direction while tackling its infrastructure needs and addressing the spending needs associated with rapid population aging. With monetary policy likely to remain accommodative for some time, macroprudential policies should help contain financial sector risks from the low interest rate environment.

Fiscal Policy

Fiscal outturns in 2019 are likely to fall short of target, which would call for a stronger adjustment in 2020. For 2019, the mission projects nominal and structural deficits of 0.2 percent and 0.8 percent of GDP, respectively, underpinned by higher social spending and compensation for priority areas. Nevertheless, there is substantial fiscal space and the level of public debt is just 8 percent of GDP. The 2020 budget draft envisages a general government structurally adjusted deficit of 0.7 percent of GDP. This is in line with the path to the MTO and the State Budget Law. Staff recommends a stronger reduction of the deficit in 2020 to unwind the positive fiscal impulse of 2017-19 and in view of the still strong positive output gap. This could be achieved by increasing savings from recurrent expenditures.

Over the medium to long term, fiscal policy should contribute to raising potential growth. In the context of substantial fiscal space, there is room to spend more on research and development, health, education, productivity-enhancing infrastructure while addressing the significant demographic challenges Estonia will confront. Over the medium term, these spending needs could lead to a slightly higher structural deficit, if room to reprioritize spending may be limited. Higher investment spending, however, should be supported by improved efficiency of public spending. This would entail a stronger framework for public investment management and a partnership framework for public-private investment. Given the ongoing wage pressures on costs and competitiveness, efforts should continue to align public sector wage growth with productivity growth.

There is consensus on the need to review the pension system, but views are mixed on making the pillar II voluntary. Overall returns from the pillar II have been modest, and investment options less flexible. Thus, proposed changes to the pension scheme include providing participants a range of options to enhance investment returns and the opportunity to withdraw their money. These problems should be addressed while maintaining the mandatory nature of the pillar II, as the culture of savings is still developing, which makes the complementary role played by pillar II savings critical. The authorities should likewise be wary of the potentially destabilizing macroeconomic effects from a large increase in consumption due to a release of pillar II savings. In light of international experiences, the mission recommends a more cautious approach by (i) analyzing the long-term impact of these changes; (ii) engaging actively and broadly with different stakeholders in the process; and (iii) making sure that the needed milestones are established for each phase of the process.

Structural Reforms

Policy efforts should be redoubled to accelerate productivity increases as demographic trends are expected to weigh on growth. Population aging, through a decline in the workforce and productivity, is projected to cut long-term growth in half by 2050. Going forward, economic performance will increasingly depend on the ability of firms to raise output per worker as there is a limited scope for substantial employment gains. Ongoing reforms include the work ability review, the reduction of the tax burden on labor, and the enhancement of the life-long learning program and vocational education system to match the evolving labor market needs. The mission welcomes plans to increase labor supply by broadening the scope of active labor market policies. Further efforts should include investing more in R&D, improving the insolvency framework to release capital for productive purposes, and continuing to develop a more flexible economic migration framework.

Inequality has declined since the crisis but remains high. While overall household income growth has been significant, during the last decade it has proven especially strong at the upper part of the income distribution. Overall relative poverty and old-age poverty are high. Enhanced social safety nets for the elderly and others at high-risk-at poverty are critical and will reduce inequality. In this regard, ongoing work to extend the coverage of unemployment insurance benefits, review eligibility, and make it more countercyclical is welcome.      

Boosting economic opportunities for women would promote growth and equity. The gender pay gap is among the highest in Europe. Faster implementation of the framework for greater pay transparency is called for, as are efforts to expand its coverage beyond the public sector. The female participation rate is already relatively high by advanced economy standards. The mission welcomes recent governmental initiatives that have sought to increase the female participation rate further by improving government support for childcare. Reducing further the participation rate gap and the gender pay gap would boost output significantly in the long run. Efforts should also aim at increasing representation of women in senior positions and on corporate boards.

Financial Sector

The financial system is strong, but macrofinancial developments need continued monitoring. Banks are adequately capitalized, profitable, and comfortably meeting their liquidity requirements. But, continued monitoring of financial sector vulnerabilities and risks is warranted. Based on credit and nominal output developments, the level of the countercyclical capital buffer should be kept at zero. The mission supports the introduction of an average risk weight floor of 15 percent for mortgage loans. This instrument alongside the loan-to-value limit, debt-to-service income ceiling and maximum loan maturity appropriately support macrofinancial resilience to potential shocks, including those arising from high household debt levels.

There is also progress in strengthening Estonia’s AML/CFT regime. Ongoing scrutiny of ML cases and efforts to resolve them have taxed resources as the financial sector faces reputational effects. But Estonia has increased the maximum fine that may be imposed on financial institutions for violations of their AML/CFT-related obligations and plans to increase it further. It has also devoted additional resources to countering illicit finance, issued extensive guidelines to supervised entities, and conducted an in-depth review of bank risk profiles. The EFSA actively uses its powers, including precepts and license withdrawals, to enforce financial institutions’ compliance with their AML/CFT-related obligations. The recent approval of a Center for Strategic Analysis is welcome, as is the initiation of an update of the national ML/TF risk assessment, which will support the further refinement of the EFSA’s conduct of risk-based supervision.

Continued reform of Estonia’s AML/CFT regime, including with respect to supervision, will be critical to mitigate evolving financial integrity and stability risks. The process to impose monetary penalties for violations of AML/CFT-related obligations needs to be streamlined, and the maximum penalty increased. Efforts should continue to increase the number of financial institutions that may be covered by inspections each year and to develop risk-based targeted and thematic AML/CFT inspections and/or further increasing resources. The recently-approved Center for Strategic Analysis should be fully and expeditiously operationalized, with strong expertise to produce the risk analysis needed. Finally, Estonia should hold internal discussions on enhancing integration/consolidation of AML/CFT supervision at the EU or Nordic-Baltic levels and arrive at a governmental position.

The mission would like to thank the Estonian authorities for their availability, candid discussions and warm hospitality to facilitate the mission’s work in Tallinn.