The Estonian Economy

The Estonian Economy
Monthly newsletter from Swedbank’s Economic Research Department
by Elina Allikalt No. 5 • 3 November 2010

Strong short-term fiscal position founded on great
adjustments during the crisis
 Successful fiscal adjustments introduced during the recession, as well as
many favourable circumstances, allowed Estonia to weather the recent crisis
without fiscal collapse. Even more important, a rapidly changing economic
situation allowed the country to meet all Maastricht criteria and become
eligible for euro adoption.

 Because of a faster-than-forecast economic recovery, budget revenues are
overshooting targets in 2010, and further increases are drafted in 2011
budget. Expenditures are also growing, supported by investments and some
one-off causes. Overall, deficits are being held under control, reserves have
stabilised, but the debt level is about to increase, although from current low
levels.

 Unlike most countries in the EU, which are primarily focusing on additional
austerity measures, Estonia can, thanks to its strong fiscal position,
concentrate more on current imbalances and problems in the economy, as
well as on other longer-term fiscal issues.

After many years of unsustainable growth rates and consecutive years. At the end of 2007,
an overheating economy, Estonia entered into reserves peaked at EUR 1.4 billion. This
recession in early 2008, triggered by collapsed provided a critical cushion in 2008-2009 to
domestic demand. The initial recession was further cover fiscal deficits because interest rates
exacerbated by the global financial crisis in late for external financing were very high during
2008, which brought the financial sector, as well as that period due to negative risk estimates
export demand, to a halt. These circumstances for the Baltic region.
called for swift action in order to stabilise the
economy in a rapidly changing environment. With a  The actions taken by the government to
fixed currency peg regime in place (and a clear adjust the fiscal position in accordance with
commitment to stick with it), “internal devaluation” the changing economic environment were
was the policy chosen to live through the crisis. quick and wide-ranging. Most of the
Through this choice, fiscal policies took the main austerity measures were introduced with
burden in the adjustment process as possible two supplementary budgets in 2009,
monetary policy options under the currency board totalling EUR 1.2 billion, or 9% of GDP.
regime were very scarce. However, unlike what Also, due to surpluses in previous years,
befell many emerging as well as advanced the fiscal position in which Estonia entered
European countries, a growing public sector deficit- into recession was stronger than those
debt spiral, its spillover to the rest of the economy, countries’ that had already been running
and, for some, the need for international financial deficits in boom years.
support were avoided in Estonia. The main reasons  The financial sector stayed stable despite
were as follows: global turmoil. Since most of the banks in
 The government had collected a substantial Estonia are foreign owned, no financial help
amount of reserves during the boom years from the government to the local banking
by registering budget surpluses for several

Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000.
E-mail: ek.sekr@swedbank.com www.swedbank.com
Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720.
Maris Lauri, +372 6 131 202. Elina Allikalt, +372 6 131 989. Annika Paabut, +372 6 135 440.


Monthly newsletter from Swedbank’s Economic Research Department, continued

Nr 5 • 3 November 2010

sector was needed (in contrast to, e.g., the The share and amount of non-tax revenues were
Parex bank in Latvia). exceptionally large in 2009 (about 25% of total) to
offset the drop-off in tax revenues, and this trend
Successful fiscal adjustments led to a budget deficit
will continue this year as well. While in the budget
of just 1.7% of GDP in 2009 (down from 2.8% in
law non-tax revenues were seen to decline by 7%
2008), allowing the government to further “take
this year, these are now expected to increase by
advantage” of the low level of the economic cycle
7% (the annual growth at the end of September
and meet all the Maastricht criteria necessary to be
was 17%). The biggest impact behind this increase
eligible for euro adoption in 2011.1
is a 20% higher inflow of grants. Also, a big
2010 budget – faster economic recovery difference in expectations has been the successful
boosts revenues selling of Assigned Amount Units (AAUs) under the
Kyoto protocol. At the same time, expectations are
The 2010 budget law was passed by the Parliament lower with respect to fines revenues (-32% annually
in December last year, based on a much more at the end of September).
negative economic outlook than was the overall
market consensus at that time. Unofficially, the Table. 2010 forecast by the Ministry of Finance
2011
base scenario by the Ministry of Finance (MoF) was 2010 budget summer
regarded as the negative risk scenario because the law forecast
government wanted to avoid any possible future Economy (annual growth):
negative adjustments in the budget as it was
GDP -2.0% 2.0%
targeting a budget deficit below the Maastricht
private consumption -6.7% -3.3%
criterion. The general government budget saw a investment (excl.
deficit of 2.8% of GDP for 2010 in a situation of a inventories) -8.0% -3.2%
2% economic decline and a 2.4% decrease in export 0.1% 15.1%
budget revenues. However, the economic recovery import -3.1% 12.8%
has been much quicker than forecast at that time,
unemployment rate 16.8% 17.5%
even far above the positive risk scenario. According
employment growth -3.2% -5.0%
to the latest MoF forecast, revenues are expected
to be overshot by about EUR 200 million, or 3.6%, gross wage real growth -4.0% -3.2%
compared with the original forecast; as a result, the Consumer Price Index 0.2% 2.6%
budget deficit is now expected to reach just 1.3% of Budget (EURm):
GDP (see table). revenues 5,401 5,596

About two-thirds of the above-mentioned increase tax revenues 3,946 4,075
in revenue expectations is attributed to higher tax non-tax revenues 1,455 1,521
collection (1.1% annual growth at the end of expenditures 5,735 5,685
September). Better economic recovery has deficit (general government) 371 181
primarily increased indirect tax collection – VAT and % of GDP -2.8% -1.3%
excises (6.3% and 9.9% growth, respectively). On
Source: MoF
the other hand, the situation in the labour market
has turned out worse than expected, affecting Chart 1. State budget revenues at the end of September
social tax (-6.9%) and personal income tax (% of annual plan)
(+2.1%2) collection and forcing the ministry to lower 100%
expectations. On average, tax collection this year is
forecast to be on the same level as last year, with 80%
strong possibilities for an even better outlook.
60%

40%

20%
1
So far, the price stability criterion had been the only one
not able to be met. But economic decline and internal 0%
PIT

CIT

VAT

(ex. grants)
taxes

social tax

excises

grants
revenues

devaluation led to deflation, which allowed that criterion to
non-tax

be met.
2 2010 (budget law) 2005-2009
PIT collection is behind plan, but positive annual growth
is reported due to smaller tax reliefs this year than usual. Source: MoF, Swedbank calculations

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Chart 2. State budget revenues and expenditures, from AAU sales (due to comparatively large
2005 - 2011
revenues in 2010) and declining dividend revenues.
(EUR billion)
The inflow of grants will continue to grow in 2011 as
7
well, with a 12% increase planned. Despite falling
6 non-tax revenues, their share in total revenues will
remain unusually large (about one-fourth of the
5 total).
4
Chart 3. Tax revenues, 2004 - 2011
(EUR million)
3
2,100
2
1,800
1
1,500
0
1,200
2005 2006 2007 2008 2009 2010 2011
non-tax rev enues f orecast budget
900
tax rev enues
Source: MoF expenditures
600

While revenues have been above expectations, 300
expenditures are being made below the plan. At the 0
end of September, expenditures were down by 2004 2005 2006 2007 2008 2009 2010 2011
1.5% in annual comparison with the total level being f orecast budget
even lower than in 2008. On one hand, the PIT CIT Excises
expenditures have been growing with respect to co- Source: MoF VAT social tax
financing of grants (+11%) and several social costs
(e.g., pensions, +4%, and parental benefits, +17%) Total expenditures are set to increase by 5% in
but, on the other hand, there has been a fallback in 2011, growing to levels that are higher than those
mandatory pension pillar transfers (a temporary seen in 2008 (see chart 2). More than half of this
freeze as part of the austerity program) and lower increase is attributed to social costs, mostly through
payments to the Health Insurance Fund (-9%; due higher pension payments but also due to the partial
to weaker social tax collection). Also, current recovery of state payments to the mandatory
expenditures are 4% lower, including a 6% fall in pension pillar, which have been frozen since mid-
personnel costs. 2009 as part of the austerity measures. Almost as
Revenues up by 2% but expenditures by 5% big an increase as in social costs is also projected
for investments; this will mostly be supported by
in 2011
energy efficiency investments carried out according
The budget draft for 2011 was approved by the to sold AAU contracts (this will also have a
government in September and sent to the temporary major effect on investments and
Parliament. According to the draft, the general expenditures in 2012). Current expenditures are
government deficit is set to reach EUR 241 million, also to increase by 4%.
or 1.6% of GDP, up from the 1.3% forecast for 2010
but lower than the 2% set in the latest state budget Reserves stable and debt to rise
strategy plan. The reserves accumulated during the boom years
Total revenues are expected to increase by 2%, with consecutive years of budget surpluses
including 4% in tax collection. All main tax revenues provided critical fiscal support during the crisis.
are envisaged to increase, with the biggest in CIT Because external financing costs were quite high
(up 12% from 2010, mostly due to a small during 2008-2009, covering deficits with reserves
comparison base) and PIT (7%; supported by was preferred. Some strategic public investments
somewhat better labour market conditions). The (e.g., to the energy company Eesti Energia) were
only planned tax increase as of now is the 10% hike financed from reserves as well. However, one loan
in the tobacco excise in January; there has been from the EIB was taken in order to cover some co-
discussion to introduce a plastic bag tax during next financing related investment costs and not to
year also but that has not been decided yet. exhaust the reserves entirely. The total amount of
reserves is forecast at 9.5% of GDP at the end of
Non-tax revenues, on the other hand, are expected this year (down from the peak of 12% in 2006). The
to decrease by 4%, influenced by smaller revenues

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budget deficits both this year and next are mostly reaching balance or a small surplus in 2014.4.The
planned to be financed by reserves. The current current government says that budget surpluses
government has also not ruled out the possibility of must be restored as soon as possible in order to
taking a loan to cover some investments, but this start increasing reserves again, which were being
will depend on whether it can get that loan with exhausted during the deficit years. One coalition
lower interest costs than the interest revenue partner recently even went so far as to propose that
earned from current reserves. a mandatory budget surplus requirement should be
written into the constitution, but as of now that idea
Chart 4. General government reserves and public debt, has not gained wider support. Estonia’s
2006 - 2014 conservative fiscal policies are regarded as its
(% of GDP)
biggest strength and are strongly linked to its
20% overall credibility.

Chart 5. General government budget balance forecast
15% according to current state budget strategy, 2005 – 2014
(% of GDP)
4%
10%
3%

5% 2%

1%

0% 0%
2006 2007 2008 2009 2010 2011f 2012f 2013f 2014f
2005

2006

2007

2008

2009

2010f

2011f

2012f

2013f

2014f
reserv es debt -1%

Source: MoF f orecast -2%

-3%
Estonia has unarguably the lowest debt level in the
EU, forecast to amount to only about 8.8% of GDP -4%
this year (compared with about 80% on average in Central gov ernment Local gov ernment
the EU). During the coming years, however, the Source: MoF Social security f unds General Gov ernment

debt level is set to increase as a larger share of
deficits are planned to be financed by loans However, reaching budget surpluses should not
because the government aims to keep reserves at a itself be a major target. Justifiable small deficits
steady level.3 This stable level of reserves will be should not be feared if they help to broaden
supported by social security funds, which will record macroeconomic stability, especially because
growing surpluses during this period (see chart 5), unemployment is forecast to remain relatively high
while local government reserves will remain for years, domestic demand will be slow to recover,
unchanged and central government reserves will and the economic recovery in debt-ridden Europe
decline. As budget surpluses resume (planned for might stall (thus affecting export demand). Estonia
in 2014), the debt level will stabilise and reserves is in a very unique fiscal position in Europe and the
will start growing even faster. euro zone – while most countries are struggling to
find ways to curb their out-of-hand deficit and debt
Short-term deficit under control, long-term levels, Estonia has the luxury of instead
challenges ahead concentrating on other economic issues (e.g.,
The current official state budget strategy for 2011- unemployment, productivity, export
2014 sees the general government budget as competitiveness, etc.). Also, almost nonexistent
public debt (at least in comparison to Europe and
other advanced economies) will impose a much

3
The debt level increase seen in chart 4, drafted in the
4
latest state budget strategy, can be treated as a negative The temporary worsening of the deficit in 2011 and
scenario, i.e., in case reserves are used at a minimum. In 2012 is mostly connected to mandatory increase in
addition, future loans are seen as being used only for spending (e.g., recovered payments to pension pillars
investment purposes, not to cover current expenditures. and investment spending according to AAU contracts).

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lighter burden on future budgets, as there is no also be offset by welcoming more immigrants into
reason to find extra means to service those debts.5 the workforce, but as of now this policy change is
Very telling in this respect is the fact that Estonia is not widely supported. Different structural changes
the only country in the euro zone to actually meet should be considered, too, in order to accelerate
all the rules set by the Stability and Growth Pact the increase in productivity.
more than ten years ago which so far have not
been reachable to the euro zone on average. Chart 7. Foreign financing in the state budget, 2003- 2011
1,200 25%
Chart 6. Public sector debt and deficit in euro zone
countries, 2010 1,000
(% of GDP) 20%

-18 800
IE 15%
Deficit

-16
600
-14 10%
400
-12

-10 5%
200
SK ES FR EL
-8
0 0%
CY NL PT
-6 2003 2004 2005 2006 2007 2008 2009 2010 2011
SI AT IT
-4 LU DE BE total, EURm (ls) f ore- budget
% of total rev enues (rs) cast
FI MT Source: MoF % of GDP (rs)
-2
EE
0
0 50 100 150
Another area of concern is the state budget’s heavy
Debt
Source: IMF WEO Database October 2010
dependency on foreign financing (i.e., grants) The
government successfully used foreign financing
(especially EU structural fund instruments6) as a
Nevertheless, despite a favourable fiscal position in supportive measure during the economic crisis, as
the short term, there are many bigger mid- and well as heavy budget cuts, simplifying the
long-term issues that need to be dealt with very application processes and targeting more means to
soon. For instance, like the rest of the developed the labour market, entrepreneurship, and
economies in the world, Estonia also has to tackle innovation-advancing areas. As a result, the
the issue of an aging population and shrinking amount of foreign financing increased to EUR 830
workforce, which are exacerbating socials costs million in 2009, contributing 15% of total revenues
and threatening competitiveness. A big step in this (or 6% of GDP). In the 2011 budget draft, that figure
regard was already taken at the beginning of this is set to increase to EUR 1,111 million, or almost
year with the government’s decision to raise the one-fifth of total budget revenues and 7.5% of GDP
retirement age from 63 at present to 65 by 2026. (see chart 7). Estonia is among the frontrunners in
Also, a new labour law took effect in mid-2009 that using EU regional policy instruments, indicating its
increased the flexibility of the labour market. high efficiency levels. However, the current
However, additional policy changes are needed. budgetary period for using this EU financing ends in
For example, further increase the attractiveness 2013; although financing revenues will not be cut off
and dynamics of the labour market in order to cap immediately after that, there will probably be a
emigration and raise participation rates. Apart from noticeable drop that could leave the budget, public
the declining size of the workforce, the biggest risk investments, and economy as a whole in a “hung
for the labour market is the growing number of long- over” mode. A more decisive framework therefore
term unemployed, and thus more needs to be done needs to be put in place to offset these possible
to decrease the probability of their becoming developments. Even more so because, depending
entirely discouraged. Some of the problems can on the development level, there will probably be

5
According to the European Commission spring forecast,
Estonia has the lowest interest payments in the EU,
6
namely, 0.4% of GDP in 2010, compared with an average EU structural fund instruments make up about 80-90%
of 3% in the euro zone and 2.8% in the EU. of total foreign financing.

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many fewer instruments available for Estonia during
the next budgetary period after 2013.
Elina Allikalt

Swedbank
Economic Research Department Swedbank’s monthly newsletter The Estonian Economy is published as a service to our
SE-105 34 Stockholm customers. We believe that we have used reliable sources and methods in the preparation
Phone +46-8-5859 1028 of the analyses reported in this publication. However, we cannot guarantee the accuracy or
ek.sekr@swedbank.com completeness of the report and cannot be held responsible for any error or omission in the
www.swedbank.com underlying material or its use. Readers are encouraged to base any (investment) decisions
on other material as well. Neither Swedbank nor its employees may be held responsible for
Legally responsible publisher
losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s
Cecilia Hermansson, +46-8-5859 7720
monthly newsletter The Estonian Economy.
Maris Lauri +372 6 131 202
Elina Allikalt +372 6 131 989
Annika Paabut +372 6 135 440

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