Economic Survey of Estonia 2009: Getting back to sustainable growth path is the key policy challenge

 

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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Estonia published on 20 April 2009.

 

Contents

 

A long boom is ending in a bust

During 2000 07, the Estonian economy experienced one of the highest growth rates among emerging market economies and, until 2005, low inflation. However, in recent years, domestic demand was mainly driven by a housing investment boom, fuelled by high expected income growth and accommodated by large capital inflows and cheap credit, as well as tax incentives. Tightening loan standards in the wake of the severe international financial crisis, falling house prices and an abrupt turnaround of consumer confidence have put an end to expanding domestic demand, which has been shrinking since mid-2008. Pro-cyclical fiscal policy is adding negative stimulus. Moreover, strong wage growth real appreciation weakened Estonia’s external competitiveness.

 

The recovery relies on shifting resources from non-tradables to exports

Estonia was one of the first countries to enter recession in 2008 and is now going through most challenging times. Real GDP growth is expected to be significantly negative in 2009 and turn positive only towards the end of the year and pick up in 2010, due to a more favourable outlook for exports. This recovery will depend on the ability to shift resources from serving domestic demand to producing for export demand. While the initial causes of the slowing and reversal of GDP growth largely affected domestic demand, Estonia is now highly exposed to external risks, especially to a deeper or more prolonged recession in the euro area and further fallout from international financial markets crisis. Even though the current-account deficit has been reduced, risks of an accelerated reversal of capital flows could lead to a further reduction of output. While a diversified small economy like Estonia may hardly hit an effective demand constraint on external markets, it might nevertheless need to accept lower prices and wages to secure the increase in export market shares necessary to compensate the collapse of domestic demand.

 

The key challenge is the return to a sustainable path of high growth

The key current policy challenge for the government is to bring the economy back to trend growth. To this end, distortions introduced during the past boom and the misallocation of resources toward the non-tradable sector will need to be corrected. However, the real exchange-rate appreciation that has already taken place will make the reallocation of resources from non-tradable to tradable sectors and an export-driven recovery more challenging. From this perspective, the following policy issues stand out:

  • Removing the pro-cyclical bias of fiscal policy. Up to now, fiscal policy has exhibited a pro-cyclical bias. Some of the windfall revenues were saved, but a considerable part was used to initiate structural tax cuts as well as, but to a lesser extent, expenditure increases
  • Strengthening financial stability and unwinding distortions in the housing market. Pro-cyclical lending conditions and wages, as well as a fiscal bias in favour of home ownership, have re-enforced each other and led to an over-expansion of real estate and construction.
  • Reforming labour markets to enhance wage flexibility as well as regional, sectoral and occupational mobility. Reallocating labour smoothly to more productive activities, typically in the export sectors, will hinge on more flexible labour markets.
  • Making the business environment even more competitive. While recent GDP growth was driven largely by capital deepening, productivity gains from innovation will need to play a greater role in the future. In that context, it will be important to remove remaining obstacles to investment, entrepreneurship and innovation.

Estonia’s alignment with the euro area is low, but has increased over time and needs to be supported by appropriate policies

The currency board introduced in 1992 has served Estonia well. The main motivation at the time was to rapidly enhance the credibility of policies and reduce inflation, effectively by taking over the monetary stance of a well reputed central bank. While the business cycle is only loosely synchronised with those of the euro area, its alignment seems comparable to some smaller EMU countries. Moreover, synchronisation of shocks and cycles with the euro area seems to have increased somewhat, mainly due to policies and institutions that facilitated EU accession. However, in the absence of exchange-rate flexibility, the response to asymmetric shocks and the consequences of the remaining cyclical divergence from the euro area will have to be mitigated by fiscal policy as well as by policies enhancing structural flexibility.

 

With inflation falling and risks originating from the international financial crisis, an early adoption of the euro has re-emerged as a key government priority. Regardless of whether this goal is achieved, given that the Kroon is pegged to the euro, the relatively low level of synchronisation implies that effective counter-cyclical fiscal policy and labour mobility are required to avoid excessive volatility.

 

How to obtain this publication

 

The complete edition of the Economic survey of Estonia is available from:

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.

 

Additional information

For further information please contact the Estonia Desk at the OECD Economics Department at eco.survey@oecd.org

The OECD Secretariat's report was prepared by Zuzana Brixiova and Laura Vartia under the supervision of Andreas Wörgötter. Research assistance was provided by Margaret Morgan.

 

 

 

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