Tallinn, June 2, 1998

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington DC 20431

Dear Mr. Camdessus:

The Government and Bank of Estonia have been implementing the program of economic stabilization and reform described in the Memorandum of Economic Policiesof November 7, 1997, which is being supported by the International Monetary Fund under a precautionary stand-by arrangement. The attached supplementary memorandum describes the economic policies that we will follow in 1998. These measures, which build upon the policies set out in the original memorandum, are designed to significantly strengthen the existing macroeconomic policy stance and accelerate structural reforms.

Significant progress has been made in achieving the program's macroeconomic objectives and in accelerating structural reforms. All quantitative targets under the program for end-December 1997 were met, some by substantial margins. All the quantitative performance criteria for end-March were also met, except for the targeted general government fiscal surplus as described in the attached supplementary MEP; however, we are confident that all the end-June performance criteria will be met. The Government will not propose any supplementary budgets after June 1. Moreover, we will not grant any further pension increase this year beyond that already approved by Parliament and effected in March. Implementation of structural measures is proceeding broadly as envisaged. The end-March structural performance criterion on the introduction of the market risk component of the capital adequacy ratio could not be met on time due to administrative delays, but this has now been completed. We request a waiver for the non-observance of this performance criterion. As we stated in our letter of November 7, 1997, we do not intend to make any purchases under the stand-by arrangement, unless circumstances warrant it.

Performance under the stand-by arrangement during 1998 will continue to be assessed through quarterly performance criteria and structural benchmarks as specified in Tables 1 and 2 attached to the supplementary memorandum. In particular, the ceilings on contracting or guaranteeing of non-concessional debt have been revised so that the general government and the Bank of Estonia cannot contract or guarantee debt of an original maturity of up to two years, other than normal import financing.

We believe that the policies described in the attached supplementary memorandum are adequate to achieve the objectives of the program, but are prepared to take additional measures should the need arise. During the period of the arrangement, we will consult with the Fund on the adoption of any further measures that may be appropriate in accordance with the Fund's policies on such consultations.

Attachments

Recent developments and overall outlook

1.  The Estonian economy continues to perform well. In 1997, economic activity turned out to be much more vigorous than anticipated and real GDP is now estimated to have grown by almost 11 percent, compared to 7 percent projected earlier, led by sharply rising domestic demand-notably private investment and consumption-as well as strong export growth. Nevertheless, inflation declined substantially, in line with the target, to average 11.3 percent in 1997. Although labor market conditions remained tight and real wages grew by just over 7 percent, their growth was well below productivity. Indications from the first quarter of 1998 are that growth is expected to remain strong during this year, at an annual rate of around 8 percent compared to the earlier target of 5.4 percent; towards mid-year the economy is likely to begin showing signs of slowing down. The rate of inflation picked up somewhat in the first quarter of 1998, mainly because of larger than expected adjustments in administered prices (notably energy), and is expected to be around 11–12 percent for the year as a whole. Inflation in Estonia is higher than the rates prevailing in major trading partners in Western Europe, which is a cause for concern. However, as the price convergence process continues, Estonia's external competitiveness does not appear to have been adversely affected.

2.  Reflecting the buoyant domestic demand, the current account deficit reached 13 percent of GDP in 1997, with the trade deficit at 25 percent of GDP partly as imports accelerated in the last quarter because of pre-announced tax increases. The deficit on the current account was more than covered by a substantial surplus on the financial account, which rose to 17 percent of GDP in 1997. Although foreign direct investment inflows continued to grow relative to 1996, about 80 percent of all capital inflows were debt-creating (often with short-term maturities), and were primarily directed to commercial banks; in turn, the banks used these resources to underpin a very rapid increase in domestic credit. In the first quarter of 1998, the trade deficit remained high (around 26 percent of GDP) and indications are that the current account deficit did not decline appreciably. For the year as a whole, and based on the continuation of the demand-dampening policies as described below, we are now targeting a reduction in the deficit to around 10 percent.

3.  Economic policies in late-1997 were aimed at dampening demand. First, the government maintained strict control over its expenditures while the faster-than-expected growth boosted revenues, resulting in a much higher-than-expected fiscal surplus in 1997, 2 percent of GDP (excluding privatization receipts), compared to a target of rough balance and a deficit of 1.5 percent of GDP in 1996.¹ Second, in the fall the Bank of Estonia (BoE) implemented a wide array of measures designed to curb the growth in domestic credit and strengthen the financial system (paragraphs 23–25).² As a result, the monthly annualized growth rate of credit to the non-government sector declined from an average of 121 percent during the third quarter to 65 percent in the fourth quarter of 1997. In addition, external borrowing by commercial banks continued into the first quarter of 1998 and, after a considerable initial tightening, liquidity in domestic money markets shows signs of easing again and interest rates fell. In the first three months of 1998, tight policies were continued as the general government ran a surplus of EEK 196 million (approximately 1.2 percent of GDP) and the growth rate of domestic credit to non-government continued to decline to 26 percent. However, the fiscal surplus was lower than the target (EEK 300 million) as revenues from excise taxes substantially undershot the anticipated amount; this was due to a larger-than-expected shift in imports of tobacco and fuel products to the previous quarter as a consequence of pre-announced increases in excise taxes effective January 1998. In April, revenue performance was strong, in particular excise tax receipts returned to normal levels.

4.  The exchange rate peg to the deutsche mark as well as the currency board arrangements continue to serve Estonia well and will be supported by the necessary domestic policies. Recent developments indicate that domestic demand pressures should abate in coming months as the economy feels the full impact of the measures taken so far. However, given the institutional features of Estonia's external regime and the size of the external imbalance at the starting point, the pace of adjustment should be faster. The balance of risks suggests that it is advisable to strengthen the existing counter-cyclical fiscal policies to restrain demand and reduce the current account deficit, accompanied by additional actions to limit domestic credit growth and short-term capital inflows. These will be combined with a continuation of measures to enhance financial sector prudential standards and accelerate structural reforms (notably privatization and land reform) to improve domestic supply conditions.

Fiscal policy and public sector reform

5.  The reinforcement of the fiscal stance will be a critical part of the policy package for 1998. The revised target for 1998 will be to generate a general government surplus (excluding privatization receipts) of at least EEK 1.9 billion, or 2.5 percent of GDP. The 1999 budget is currently under preparation. We anticipate that the final budget will be consistent with a general government surplus of the same magnitude relative to GDP next year, or higher if the external current account deficit for 1998 does not decline in line with expectations.

6.  On the revenue side, we do not intend to introduce new taxes in the midst of the 1998 fiscal year but will continue to keep some tax rates under review. We have already taken most of the measures envisaged in the MEP, the main exceptions being the introduction of a national car tax and the tax on offshore operations of companies (paragraph 16). We have also incorporated into the 1998 budget an increase in state duty fees and in receipts from the sale of state buildings. Boosted by these various measures as well as rapid economic growth, general government revenues are expected to increase significantly. However, we are conservatively projecting revenues to decline slightly as a share of GDP from about 39 percent in 1997 to just over 38 percent this year.

7.  The focus in 1998 will be on containing expenditures, notably current expenditures. Building on successful efforts to limit spending in 1997, we intend further to reduce current spending of the general government by 1 percentage point to 32 percent of GDP, less than the original target of 34 percent of GDP. To this end, in 1998, we shall not submit to parliament any supplementary budget which would result in a reduction of the surplus below the levels described in this memorandum. Moreover, we anticipate that there will be underspending of the order of EEK 300 million of central government budgetary allocations.

8.  We shall ensure that the general government surplus generated in 1998 will be sterilized so as to have its full contractionary effect. In addition, we are also proceeding as scheduled with the sale of 49 percent of the government's shares in Eesti Telekom, which is now expected to be undertaken in October-November 1998. From the sale of these and other state assets, we will save at least EEK 500 million through the Stabilization Reserve Fund (SRF) in 1998. All told, we shall raise the amounts to be transferred to the SRF to EEK 2.1 billion from our original target of EEK 1.2 billion, bringing the balances in the SRF at end-1998 to at least EEK 2.8 billion (3.6 percent of GDP). As of June 1998, up to 25 percent of the total SRF resources will be held domestically at the Bank of Estonia at all times. No resources of the SRF will be spent in 1998 or beyond until the Fund has been formalized.

9.  Consistent with the broad aim of protecting the economy against macroeconomic risks, SRF resources will be used to meet carefully selected long term obligations of the state with the highest priority being given to meeting the government's liabilities related to the planned fully-funded tier of the reformed pension system. Following that, some resources could be used for a few core infrastructure projects with critical national impact which the private sector is unlikely to be able to undertake. At present, the SRF is a special account at the BOE, which acts as executing agent of the Ministry of Finance (MoF), as specified in last year's Memorandum of Economic Policies. Before end-1998, we will begin the process of formalizing its objectives and operations with the aim of transparency and accountability as part of the Basic Budget Law. By January 1, 1999, we will formalize the legal existence of the SRF, establish guidelines governing the short and medium-term investment strategies of the SRF, and spell out the procedures for determining the percentage of the fiscal surplus to be channeled each year to the SRF; this proportion will be at least 50 percent of the anticipated annual surplus and will be transferred to the SRF on a regular basis during the year, for instance, once each quarter. We will specify the procedures by which SRF balances can be spent and the purposes for which such spending can take place. In this regard, we will establish by end-September 1998 an independent and broad-based oversight committee for the SRF composed of selected members of government, specialists in finance, and representatives of non-government bodies. This committee will advise on the circumstances warranting use of the SRF resources.

10.  In recent months, we have made significant progress in laying the groundwork for the move from the current pay-as-you-go pension system to a three-tier partially funded scheme (paragraph 20). As a major step forward, in April, parliament approved a new Social Tax Law, which provides for registration of individual contributions, a precondition for the introduction of the reformed first tier. Also in April, the government submitted to parliament a Pension Law, which would link benefits to individual contributions; this law also included appropriate amendments to the Income Tax Law so that it will be consistent. In addition, a law on private pension funds—the third tier of the new system—is in its third reading in parliament. On the basis of this legal framework, we shall introduce the system of voluntary contributions (third tier) in July 1998; the first tier, including a minimum pension and a component based on length of service and contributions, on January 1, 1999; and the mandatory contribution-based second tier by January 1, 2001. As part of the overhaul of the pension system, responsibility for collecting the social tax will be transferred to the National Tax Board on January 1, 1999.

11.  We remain committed to rationalizing and streamlining public expenditures, though there have been delays in implementation, some of them linked to the need to build a political consensus. In the area of health care, a five-year reform is under way with the assistance of the World Bank, to rationalize physician and hospital care. As part of this reform, by end-1998 we will unify accounting and centralize administration of the regional medical funds. Following this administrative reform, the number of regional funds will be reduced. In preparing for further civil service reforms, we are proceeding as planned with a review of employment in the education sector by September 1998, and in state agencies and local governments by December 1998.

12.  Estonia's budgetary procedures and data need further improving in order to ensure stronger implementation and monitoring of fiscal policy and developments. We are therefore taking the following steps:

• Transfer of responsibility to the state Treasury for monitoring all foreign loan disbursements to the general government as well as repayments of foreign loans on lent by the central government. This will be completed by June 1, 1998, a few months later than anticipated because of a shortage of trained personnel.

• Strengthening of Treasury operations is being undertaken through a large-scale computerization program aimed at enhancing cash management, debt management, and the budget process, by facilitating the exchange of information across departments and regional offices. A master plan has been completed, partial financing obtained from the EU, and implementation will begin in 1998.

• Changes in legislation for the 1999 budget to be presented on the basis of the consolidated central government (including all extrabudgetary funds and the utilization of foreign loans). As planned, these amendments will be submitted to parliament by September 30, 1998.

• Changes in data compilation. Efforts will be made to improve the timing and reliability of both fiscal data and reporting by various funds (See Annex on Data Issues).

13.  While the monetary and prudential measures adopted late last year have been effective in reducing the rate of growth of domestic bank credit, the pace of expansion is still rapid, and the continued borrowing abroad by commercial banks especially at short maturities remains a matter of concern. In a continuing effort to improve the effectiveness of the measures already taken late last year, by July 1, 1998, the Bank of Estonia will implement the following amendments to the mandatory reserve requirements: first, the cash component will be reduced from 30 percent of required reserves to 20 percent thereby raising the reserve holdings at the central bank; second, financial guarantees provided by commercial banks to other financial institutions will be subject to the mandatory reserve requirements.

14.  We are monitoring monetary and external developments very closely. A careful analysis of developments through April suggests that there is no need for further monetary tightening at this stage. However, if monetary aggregates through June indicate that the present trend of declining credit growth is not being sustained and that external borrowing continues unabated, or if the evolution of the balance of payments is not consistent with the annual targets for 1998, we will inter alia take the following corrective measures before September 30, 1998:

• Limit to 50 percent the extent to which foreign interbank liabilities can be offset against assets for the purposes of the calculating the base for the reserve requirement. If necessary, the reserve requirements will be extended to gross foreign liabilities.

• Impose additional non-remunerated reserve requirements on short-term (up to 2 years) liabilities towards financial institutions and on newly-issued short-term securities.

In light of the substantial structural and institutional changes underway in the banking system, we may consider any alternative measures with a comparable impact on domestic credit growth and the external financial accounts, including further increases in the effective mandatory reserve requirements.

15.  The Bank of Estonia is determined to implement the best international practice as a means of ensuring a solid and stable financial system in the country. A recent IMF mission concluded that Estonia meets 21 of the 25 Basle Core Principles, with the exception of those related to capital for market risks, consolidated supervision, loan classification and loan loss provisioning, and country and transfer risk. In a continuation of the efforts undertaken so far by the Bank of Estonia to strengthen the banking system, by July 1, 1998, the following important measures either have or will become effective:

• All banks are required to report on a consolidated basis from the first quarter of 1998. They will follow from the second quarter of 1998 the consolidated capital adequacy regulation which includes an allowance for market risk and is in compliance with the EU capital adequacy directive. In order to ensure that banks do not circumvent any prudential regulations, we are substantially strengthening the capabilities of the Bank of Estonia's banking supervision department.

• As part of market risk limits, the absolute net foreign exchange positions of banks for currencies of all OECD countries, including the aggregate DM/EEK position, cannot exceed 15 percent of own funds. This will help limit the currency exposure of commercial banks in the event of negative external shocks.

• By July 1, banks will be informed that the present liquidity regulations will be amended, effective September 30, 1998, to include detailed provisions against maturity mismatches and interest rate risk. Penalties on non-compliance by banks will be enforced as of December 31, 1998.

• To strengthen prudential and supervisory standards further, uniform six-category loan classification procedures will be implemented for all banks.

16.  By end-September 1998, we will review the risk-weighted capital adequacy ratio and, if necessary, raise it to 13-15 percent by end December 1998; effectively implement regulations based on the Basle accords for country and transfer risk; and introduce new disclosure requirements for commercial banks aimed at more extensive public dissemination of financial information on a routine and frequent basis. As a result of all the measures described above, before the end of this year Estonia's banking system will meet or exceed all the internationally-accepted prudential guidelines set out in the 25 Core Principles by the Basle Committee.

17.  Regarding the legal and regulatory aspects of banking, the recent passage of the Deposit Insurance Law was a major step forward. Amendments to the Credit Institutions Law, which will strengthen the supervisory authority of the BoE, will be submitted to parliament by July 1998. The draft Securities Law has been divided into three related parts: the Securities Market Act, covering the powers of the Securities Inspectorate, functions of investment firms, and capital adequacy requirements for investment firms, to be submitted by September 1; the Law on Central Registration of securities, to be submitted by end-September; and the Investor Law which, in line with EU directives, provides limited investor protection in cases of investment firm fraud, to be submitted by end-September. Finally, we are also building a framework for unified supervision of financial institutions, and an inter-agency working group will prepare concrete proposals for the unification principles and timetable for completion by end-year.

Other structural policies

18.  Structural reforms during 1998 are aimed primarily at completing programs that were initiated over the past five years. They focus on three areas, i.e., the restructuring and privatization of the large enterprises remaining in state hands; an acceleration of land reform; and a strengthening of the legal framework in accordance with EU requirements. In a major step, we have amended the Competition Law (February 1998) to conform to EU norms. Moreover, we reaffirm that, under the existing Business Law, the central and local governments are not responsible for the financial liabilities of any state-owned enterprise and there will not be any implicit or explicit guarantees on the external and domestic borrowings of these enterprises.

19.  In mid-April, we adopted a far-reaching privatization program for this year, which maps out the privatization process for the major infrastructure companies, and calls for almost 20 commercial enterprises to be privatized in 1998. We are on track in implementing the plans for the infrastructure companies, which include:

• Eesti Telekom: The sale of 49 percent of the government's shares in Eesti Telekom will start by October 1998, with a major proportion being offered on international stock exchanges.

• Eesti Energia: The first part of the 3-track process is the separation of the two major power stations from the holding company (Eesti Energia), to be completed by this summer, and the subsequent creation of two joint stock companies, Narva Power and the Tallinn City Power generating company. We intend to sell 49 percent of Narva Power to a foreign strategic investor, and the business plan is expected to be submitted to the Privatization Agency by end-June. The other power generating company will be partly sold to the city of Tallinn and partly privatized; no date is set for this privatization. The second track regards the sale of the seven distribution companies, two of which are to be privatized this year. Finally, power transmission will be formed into a separate company for privatization later this year.

• Eesti Polevkivi (oil shale): The government's strategy is to sell this company (which has already been turned into a joint stock company with 16 subsidiaries) to one of its clients, i.e., the power generation companies. Thus, the privatization of Eesti Polevkivi is scheduled to begin after the privatization of the power generation companies.

• Eesti Raudtee (railways): Having set up the state-owned holding company (which owns the railway land and is the sole grantor of concessions), we have divided the operational and management components into 5 subsidiaries (freight operations, international passenger travel company, domestic passenger company, a repair works company, and suburban commuter rail company). Before end-1998, we will begin selling the majority of shares in all of these subsidiaries to private investors.

20.  Of the non-infrastructure companies up for privatization this year, we will complete in particular the sale of Liviko and Moe Spirit (currently 49 percent and 33 percent in private hands, respectively), by end-1998.

21.  We have removed a major obstacle to land privatization by having completed processing claims on 95 percent of all restitution cases. We had privatized 16 percent of total land by end 1997, and will be able to privatize at least 27 percent of total land by end-1998, somewhat below our original target of 35 percent. The combination of completed restitution and amendments to the 1996 Law on Land Reform in late 1997 will: accelerate privatization of currently unused state-owned land through simplified auction procedures; foster privatization of state land used by agricultural enterprises by allowing preferential sales to current users, offering long-term transferable lease agreements, or through auctions; and promote private ownership of household lots by offering selective price reductions.

22.  Land purchases by foreigners are still subject to some legal restrictions. Removal of these restrictions is necessary for harmonizing the legal framework of land reform to EU laws. We intend to submit to Parliament the necessary amendments to the Land Law and the Real Estate Acquisitions Law by end-1998.

Fiscal data requirements: At present, final data on government operations are available only with a lag of up to six weeks, and are not provided systematically for the consolidated general government. In order to address these shortcomings, the MoF will: (1) issue a regulation by June 30, 1998, making obligatory, for all local governments and extra-budgetary funds, the reporting of monthly data within one month of the end of the reporting period, as of January 1999; (2) issue any necessary clarifications to local governments and extra-budgetary funds on the method of compiling and classifying data to allow proper consolidation; and in addition, by September 30, 1998, the MoF will begin compiling monthly data on foreign borrowing of the general government and repayments to MoF accounts; and (3) provide as of January 1999, on a monthly basis, fiscal data for the consolidated general government. Finally, the BoE and MoF will make every effort to jointly prepare a monthly analysis of financing for the general government consistent with above-the-line data on revenue and expenditure.

Data publication: Estonia will subscribe to the International Monetary Fund's Special Data Dissemination Standard by September 30, 1998.