At the time of the last Article IV discussion on Estonia in
June 1999 my Estonian authorities affirmed their interest in
concluding discussions for a new precautionary stand-by
arrangement (SBA) during the fall of 1999. This commitment has
materialized, and I want to thank the staff on behalf of my
Estonian authorities and myself for their efforts and frank, as
well as constructive, discussions which helped the authorities to
develop this ambitious program.
Following "irrational exuberance" in the Estonian
financial markets in 1997 and the outbreak of the Russian
crisis a year later, Estonia has experienced its first
cyclical slowdown since the beginning of the transition. The
GDP growth dropped from nearly 11% in 1997 to an estimated
-1% in 1999, the fiscal balance turned from a surplus of 2%
of GDP in 1997 to a deficit of about 4.7% of GDP in 1999.
Financial assets were priced sharply downwards, domestic
credit contracted and the banking sector passed through a
wave of consolidation. Nevertheless, the external current
account narrowed substantially, despite the contraction of
the CIS markets and the widening budget deficit.
The Asian contagion, the sharp contraction of eastern
export markets after the Russian crisis, and volatile
international financial markets put the economy and economic
policies in Estonia to a real test. The Estonian economy
proved its resilience, the economic policies withstood
pressures, and adjustment occurred in an orderly way. While
the growth of total exports turned negative at the end of
1998, exports to the European Union (EU) continued to grow.
The Currency Board Arrangement (CBA) successfully passed
market tests and, although the fiscal policy missed the set
targets, largely because of recession, the budget deficit was
reduced in the second half of 1999. The financial sector
emerged from the crisis stronger than ever, with more than
90% of the banking market controlled by Nordic banks.
Moreover, the supervisory framework was strengthened and
Estonia maintained favorable credit ratings.
The Estonian economy has by now largely completed the
adjustment process induced by external shocks and economic
activity is picking up. The exporting sector started to
revive in the third quarter of 1999. The first signs of
recovering domestic demand became evident in the last
quarter, as credit growth was edging up and imports of
investment goods surged. Increasing demand in the EU supports
the recovery in the exporting sector, which is the main
engine for sustained growth. Given an improved outlook for
the global economy, and having undergone a domestic
restructuring process, Estonian exporting industries are well
placed for a new expansion. On balance, for the year 2000,
Estonia expects its economy to grow by 4%, CPI inflation to
be around 4%, and the current account to widen somewhat.
Let me now turn to the main policy commitments the
authorities have undertaken. In this connection, the
authorities want to emphasize that the policies embodied in
the SBA and briefly discussed below are also an integral part
of the Medium-Term Economic Program for the period 1999-2003
which sets out Estonia's economic policy framework of the
national EU accession strategy.
Monetary and financial policies
The Currency Board Arrangement has served Estonia well for
almost 8 years, and remains the cornerstone of Estonia's
economic policies. Estonia has already been conducting active
accession negotiations with the EU for two years, and this
process will end with a full
membership in the Economic and Monetary Union (EMU). My
authorities believe that the CBA remains the most suitable
monetary framework up to that time, ensuring the real and
nominal convergence of the Estonian economy with that of the
eurosystem by the time of the actual transition to euro.
The Estonian authorities see two arguments supporting this
proposition. First, the CBA has proved its robustness during
the full economic cycle and has successfully withstood
various shocks in the course of the past years. The real
sector has demonstrated remarkable flexibility in adverse
economic conditions and thus supported the resistance of the
existing monetary arrangement against internal and external
economic shocks. Second, the CBA is, in principle, consistent
with the ERM2 requirements for exchange rate stability and
also with the EMU principle of exchange rate policies being a
matter of common concern, as it excludes the use of monetary
and exchange rate policies as an adjustment channel to
shocks.
My authorities also want to stress the bilateral nature of
this process. A changeover from
the CBA to the euro will take place according to a mutually
agreed accession strategy between Estonia and the EU
institutions. Initial
discussions have been held on the issue of the suitability of
a CBA as a compatible monetary framework for joining the EMU,
including at two seminars organized last November by the
European Central Bank and the European Commission. We are
also pleased to note the staff's firm support of the
authorities' position, as can be seen from the staff
reports.
As a part of EU accession process, the authorities are
committed to completing the detailed analysis of Estonian
monetary legislation during the course of 2000 to ensure its
compatibility with the EU acquis and to submit
necessary amendments to the legislature by the end of 2001.
While the CBA remains unchanged, they are also actively
working on the review of the current monetary framework, with
the aim to reduce market distortions and to achieve full
compatibility with the eurosystem over the medium term. The
review specifically addresses the current structure of
reserve and liquidity requirements, as well as the rate of
remuneration.
The authorities intend to further strengthen the
regulatory framework and the financial sector safety net. To
this end, Estonia is participating in the FSAP/FSSA pilot
project. We expect the initial assessment to be completed by
the end of March. In order to adapt the supervisory framework
to market developments, the authorities aim to finalize the
organizational and legal principles of a unified supervisory
agency by the end of June 2000. A formalized framework for
addressing systemic risks in the financial sector, including
the division of specific responsibilities between the
Government and the Bank of Estonia, will be established by
the end of this year.
Fiscal policy
Fiscal consolidation and streamlining of public finances
are at the heart of the program. The fiscal policy slippage
in 1999 was largely due to a combination of two factors. In
the run-up to local and parliamentary elections, growth
forecasts for 1999 were overly optimistic and, as the
recession was steeper than expected, fiscal targets turned
out to be unattainable. The new government implemented
expenditure cuts, including a "negative" supplementary
budget, and the fiscal position improved significantly in the
second half of 1999. The authorities have expressed their
firm intention to return to fiscal balance by 2001, and will,
in the meantime, limit the deficit to 1.25% of GDP for 2000.
This will gradually reduce the government's share in the
economy. The authorities are also ready to implement
contingency measures should revenues fall short of the
targeted level. Over the medium term, my Estonian authorities
aim at a broad budget balance.
Effective January 1, 2000 the corporate income tax on
retained earnings was eliminated. Impact of the abolition of
corporate income tax is compensated by the tax policy and
administration measures. Authorities believe that this will
eliminate inefficiencies stemming from the double taxation of
profits and boost investments.
The SBA foresees a continuation of the comprehensive
reform of public finances. Reforms
are driven by EU accession requirements and aim at
strengthening the administrative capacity of the government
sector. The government has
already made progress in this area. The Ministry of Finance
periodically publishes general
government accounts and has considerably strengthened the reporting and risk management of the
Treasury. Submission of the draft of the State Budget Act,
which reflects the requirements of the Stability and Growth
Pact, to Parliament by July 1, 2000, is among the
authorities' top priorities. The draft legislation
stipulates that all government revenues and expenditures,
including those financed by foreign loans and transfers, are
included in the budget. The new State Budget Act would also
strengthen the central government's ability to better
control the general government operations. The Government has
already submitted a draft legislation to the Parliament which
will increase the transparency of public employment and
remuneration.
The Stabilization Reserve Fund (SRF) continues to be an
essential part of the medium-term budgetary framework. In
1999 the Parliament passed legislation which
institutionalized the SRF effective January 1, 2000, and
stipulates the sources and use of SRF balances, as well as
its governing structure. The authorities anticipate that the
bulk of the SRF resources will be used to finance the pension
reform. However, the SRF also continues to serve as a cushion
against unexpected and severe macroeconomic shocks.
The authorities are aware of the increase in expenditures
which is associated with the EU accession. While the outlays
are particularly sizable in the area of the environment,
energy and transportation, they will be financed in
substantial part through grants under the different EU
programs. As a result of preparations for joining NATO,
Estonian defense expenditures will increase to 1.6% of GDP in
2000 and could require some further increase over the medium
term.
Structural reforms
Implementation of the pension reform is a key for ensuring
long-term fiscal sustainability. Financing options of the
second fully funded pillar, which has the largest
macroeconomic implications, will be discussed in Government
shortly. The authorities are committed to present relevant
legislation to Parliament by December 2000 at the latest, and
full implementation is expected in late 2001 or early 2002.
The authorities have also requested technical assistance from
the World Bank and the IMF in connection with the pension
reform. In combination with health care reforms, this will
lead to a more efficient social safety net.
Estonia has reached the final stage of privatization. My
authorities are committed to divest their remaining
shareholdings in Estonian Telecom. Also, the privatization of
the major freight and transit line Estonian Railways is
expected to be concluded by the end of 2000. Moreover, the
authorities have put major effort into privatizing the
complex power generation and distribution network.
Negotiations with the US based energy company NRG Energy are
proceeding well and are expected to be completed by the end
of June 2000. In this regard, the authorities also seek to
ensure a high degree of competition among energy producers
and are committed to provide the Energy Inspectorate with
sufficient regulatory powers and resources. The authorities
are well aware of the economic dislocation which is
accompanying the rationalization of an inefficient energy
system, and are seeking assistance from the World Bank to
develop a framework for the development of northeast Estonia,
the region which is mostly affected by restructuring.
Transparency initiatives
Finally, my Estonian authorities wish to confirm their
commitment to adhere to the best standards and practices of
transparency of economic policies. Estonia has subscribed to
the SDDS and is participating in the pilot project of the
publication of Article IV staff reports. The authorities have
planned to initiate an assessment of compliance with the Code
of Good Practices in Fiscal Policies by July 2000. An
assessment of compliance with the Code of Good Practices in
Monetary and Financial Policies is already underway in the
framework of the FSAP exercise.
