Mission Concluding Statement 

Republic of Estonia: Staff Concluding Statement of the 2024 Article IV Mission

April 15, 2024

Tallinn, Estonia: Recent shocks have triggered supply side disruptions and a large rise in inflation. Inflation has now eased, but price and cost levels have shifted up compared to the euro area average, hurting competitiveness. Low and falling productivity growth could take a further toll on external performance and weigh adversely on Estonia’s longer-term growth prospects. These problems are not insurmountable but require a decisive policy response. After a neutral fiscal stance this year, staff advocate for a return to fiscal consolidation to rebuild policy space as the economy exits recession, alongside decisive structural measures to lift productivity and financial policies to preserve bank capital buffers.

Context and Recent Developments

1. The economy is caught in a prolonged recession. Against expectations of a rebound in the second half of last year, contraction in economic activity has extended further, along with stalling productivity and weak external performance. Soft demand from key trading partners and loss of competitiveness have depressed exports, forcing firms to cut back on investment. While the labor market remained resilient and companies hoarded jobs until recently, fading prospects of an imminent recovery and increasing real wages have started taking a gradual toll on employment, even though vacancies are still reported in certain sectors. In turn, rising unemployment, combined with tighter financial conditions, has weighed on disposable income and private consumption despite higher real wages.
2. Inflation has eased. Driven by lower energy prices, easing supply chain disruptions, and increasing economic slack, headline inflation declined steadily to below 4 percent before rebounding on a 2-percentage point VAT hike. Real wage growth has started moderating recently but remains well above productivity growth.

Outlook and Risks

3. Growth is poised to make a gradual comeback in 2024. After stagnating early in the year, growth is projected to recover, initially led by a rebound in export markets. The recovery is seen gradually spilling over to domestic demand as improved business confidence and easing financial conditions encourage firms to revisit investment and, eventually, hiring plans. In turn, better job prospects along with receding inflationary pressures support real disposable income and consumption. The slow start in the year is set to hold back average 2024 growth at -0.5 percent, but the recovery should gain further momentum in 2025.
4. But disinflation is set to slow down in the near term. Despite weakening labor market conditions and recent signs of wage moderation, earlier generous public sector agreements and minimum salary increases have already locked in sizable wage gains for the year. Near-term wage growth along with the recently enacted VAT hike are expected to keep average inflation at around 4 percent in 2024, twice the euro area’s inflation target. Disinflation is expected to resume in 2025.
5. Scarring effects from recent shocks are expected. The recovery should extend into the medium term as fiscal and monetary policies become mildly supportive under the baseline. However, despite the cyclical upswing, permanently higher level of prices and input costs combined with weak productivity growth are expected to leave a scar, weighing adversely on Estonia’s external performance and on potential output, estimated to grow at around 2 percent in the medium term.
6. This baseline is uncertain, with risks still skewed to the downside. On the domestic front, the prolonged cyclical downturn may intensify calls for increasing public spending while aborting plans to raise revenue. External risks are also significant. Increasing fallout from Russia’s war on Ukraine or an escalation of the conflict may further disrupt trade in the region and lead to a new wave of refugees. The resulting volatility in commodity prices and renewed supply disruptions may trigger an abrupt downturn in the European economy and especially in Estonia’s main trade partners, derailing prospects of recovery.

Focus on Regaining Competitiveness

7. A well-coordinated policy response is needed to restore competitiveness. The current downturn reflects not only cyclical, but also structural forces. Estonia has lost significant export market shares in the last two years, but problems predate recent developments. External performance started weakening soon after the Global Financial Crisis, with productivity growth failing to keep up with real exchange rate appreciation at times. The latest shocks have only exacerbated this trend. These problems are not insurmountable, but require a decisive policy response, encompassing a return to fiscal consolidation as the economy exits the recession along with targeted structural measures to regain competitiveness and financial policies to preserve bank capital buffers.

Fiscal Policy—Preparing for Consolidation

8. Estonia is facing difficult fiscal policy decisions. The budget deficit is projected to reach 3.5 percent of GDP this year, with risks skewed to the upside on potential revenue shortfalls. The public debt-to-GDP ratio, while low, is expected to rise over the forecasting horizon and interest payments are absorbing a growing share of spending. At the same time, spending pressures are accumulating. Emerging needs to strengthen national security and accelerate the energy transition add to long-standing aging-related spending pressures. Earlier changes in the pension system have made contributions to the second pillar voluntary, leading to large withdrawals, and resulting in potential fiscal pressures in the longer run. Insufficient quality and coverage of healthcare services may further add to these pressures. And a broader question is emerging whether to retain the country’s competitive tax environment or move closer to a social welfare model with broader provision of public services and a stronger social safety net.
9. Prudent fiscal policy is needed to support competitiveness and preserve buffers. In the near term, staff support a neutral fiscal stance, given the prolonged cyclical downturn and the negative output gap. However, as the economy exits the recession, resolute revenue and spending measures should be ready to support fiscal consolidation and preserve policy space to lift productivity and foster structural transformation. Fiscal expansion, for example in the form of abandoning plans to raise fiscal revenue, would not improve Estonia’s external performance and would further erode the buffers needed to counter future spending needs.
10. Measures should be considered on both the revenue and the spending side. Staff recommend the authorities i) promptly adopt the car registration and road tax, with the dual objective of raising tax revenue and support a more ambitious green transition; ii) identify revenue measures worth one percent of GDP already planned in the budget strategy; and iii) accelerate the implementation of updated land taxable values and lift the exemption on primary residence plots, while considering the introduction of an immovable property tax. The combined effect of a higher personal income tax rate and a basic allowance for all taxpayers is set to lower revenue and reduce the overall progressivity of the tax system from 2025. In this context, staff encourage the authorities to assess whether the structure of the tax system meets the intended degree of progressivity. On the spending side, the public sector wage bill expanded considerably in 2023 on the back of ad hoc agreements with specific workers’ categories. Going forward, it is critical to contain public sector wages while limiting the discretion of line ministries, local authorities, and independent government agencies to raise wages. Staff welcome the ongoing spending reviews and encourage the authorities to introduce means testing for social benefits.
11. The scope for strengthening the fiscal framework should be explored. The changes in the national budget rule have made the fiscal framework less ambitious, while the low government debt ratio reduces the sense of urgency for fiscal consolidation, needed to prepare for future spending pressures. The uncertainty in assessing the volatile output gap and the structural balance further complicate matters. Among the options that could be considered to anchor the fiscal path more effectively is the introduction of a spending rule. Strengthening the resources and technical capacity of the Fiscal Council would be important, along with a review of its governance arrangements.

Financial Policies—Monitoring Risks and Preserving Capital Buffers

12. While still contained, financial stability risks have increased, reflecting the prolonged recession and tighter financial conditions. Developments in commercial and residential real estate warrant close vigilance, given the higher level of leverage among companies operating in this sector and the high concentration of real estate loans in banks’ credit portfolios, including for less significant institutions. Staff recommend that the authorities review bank exposures and ensure that credit risk is properly reflected in risk weights across the banking system.
13. The current macroprudential stance is appropriate. Despite the recent lending slowdown, staff support the decision to leave the countercyclical capital buffer at 1.5 percent, given rapid credit growth observed in recent years. Staff also concur with the recent reduction of the reference rate used in debt service-to-income calculations, which had become excessively stringent. Recent efforts to improve uniformity of regulatory practices for less significant institutions, including use of Supervisory Review and Evaluation Processes, are welcome. Building on that progress, scope for higher macro- and microprudential buffers should be considered.
14. Initiatives aimed at targeting bank profits to secure public funds weaken capital buffers. Higher bank profits are largely of cyclical nature. Banks are already experiencing declining lending volumes and higher funding costs and, over time, will likely face weakening asset quality. Against this backdrop, windfall taxes on excess profits and initiatives encouraging higher taxable dividend payouts should be avoided as they divert potential sources of capital from banks, reducing their ability to build buffers and absorb future shocks.
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, continuous 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—Supporting Productivity and Fostering Transformation

16. Measures to boost competitiveness and counter structural headwinds are a priority. Against the backdrop of a structural decline in productivity growth, falling export shares with key trading partners, and lower potential growth, greater emphasis should be placed on supply-side policies. This includes measures aimed at increasing the quantity and quality of corporate investment, improving the allocation of labor and capital towards higher value-added products and services, enhancing the adoption of digital technologies in traditional sectors, and ensuring that real wage growth remains closely aligned with productivity growth.
17. Staff encourage the authorities to build further on their progress in supporting labor reallocation. Insufficient labor reallocation across sectors and firms has contributed to lower productivity growth. While unemployment is rising in manufacturing and construction, skill shortages have constrained growth in information and communication technology and vacancies are reported in defense, healthcare, and education. Staff welcome ongoing efforts to address labor mismatches and support reallocation through active labor market policies. Building on this progress, the authorities are encouraged to improve targeting of these schemes to cover segments of the labor market not sufficiently addressed and design outreach strategies to raise awareness. Scope for lifting immigration quotas should be assessed, while ensuring that minimum sectoral salaries properly reflect skills and qualifications. Efforts to reduce gender inequality in higher education and the labor market should be further pursued.
18. R&D investment and adoption of digital technologies in traditional sectors could be enhanced. Targeted R&D subsidies and grants, especially in high social return sectors like green technologies, may encourage applied innovation across firms and support the quality of corporate investment. Public investment in basic scientific research with broad economic applications may further support productivity and innovation. Public-private cooperation, including with universities, can create positive synergies at lower cost for public finances.
19. Estonia’s economic transformation would also be supported by a more ambitious green transition. At current policies, Estonia’s goal to achieve climate neutrality by 2050 is out of reach. Phasing out the domestic oil-shale sector, introducing a carbon tax, and extending the coverage of the Emissions Trading System, currently the lowest in the EU, remain key to achieving EU climate objectives. Fossil fuel subsidies should also be revisited with a view to facilitate decarbonization. Staff welcome the recent progress in accelerating deployment of renewables and urge the authorities to boost energy efficiency in the building and road transport sectors.

The mission would like to thank the Estonian authorities for their warm hospitality, close collaboration, and insightful discussions.