IMF Concludes 2022 Article IV Consultation with Republic of Estonia

Washington, DC : The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1]with the Republic of Estonia.

Russia’s war in Ukraine and the upsurge in inflation have significantly slowed Estonia’s strong recovery from the COVID-19 shock. Economic activity and the health system have been broadly resilient to COVID-19 and have progressively adapted to the pandemic, despite the high caseload from the recent Omicron wave. The sharp output rebound in 2021 was mostly driven by large policy support, pension savings withdrawals, and strong foreign investment. However, the economy is vulnerable to fallout from the war in Ukraine and the related sanctions, although direct exposures to Russia and Ukraine through trade, services, and financial channels appear to be contained. Economic activity has held up in the first quarter of 2022, displaying a solid output growth despite early headwinds from the war. In parallel, inflation has continued to surge, reflecting high imported energy and food prices, growing domestic demand, spillover effects on other prices, and supply chain disruptions. In parallel, the arrival of Ukrainian refugees seems to have slightly eased labor shortages.

Economic growth is expected to slow this year and recover over the medium term, but downside risks are high. Growth is expected to weaken to 1¼ percent in 2022, owing to trade disruptions, a drag from higher energy prices, lower confidence, and lingering supply bottlenecks. Growth is projected at 2.2 percent in 2023, and over the medium term it would gradually recover to its potential clip of around 3½ percent. Inflation is expected to start easing in the second half of this year but is projected to remain well in double digits on average this year, before falling markedly from 2023. The balance of risks to growth is tilted to the downside, primarily due to ongoing uncertainty and spillovers from the war, potential spillovers from trading partners and sanctions, and the normalization of monetary policy. Persistent supply shortages combined with upside surprises in domestic demand, and the associated entrenching of elevated inflation could create risks of a wage-price spiral and start to erode competitiveness. On the upside, good implementation of the Resilience and Recovery Plan (RRP) would support growth.

Executive Board Assessment2

Executive Directors agreed with the thrust of the staff appraisal. They welcomed Estonia’s strong economic rebound from the pandemic on the back of sound macroeconomic fundamentals and an effective policy response. Directors highlighted, however, that the spillovers from Russia’s war in Ukraine are increasingly weighing on Estonia’s economic activity and have clouded the outlook with downside risks, including the possibility of weaker growth and higher inflation. Against this backdrop, Directors agreed that policies should continue to tackle the challenges brought on by the war, while being mindful of the inflation-related challenges to safeguard macro-financial stability. Enhancing energy security and reinvigorating structural reforms to maintain competitiveness and bolster inclusive growth are also paramount.

Directors welcomed the use of the fiscal space to meet the considerable spending needs arising from the war in Ukraine. Going forward, they stressed that fiscal policy should be agile and responsive to changing conditions, which requires enhanced contingency planning. In particular, should inflation fail to decline as expected in the near-to-medium term, Directors agreed that a stronger fiscal consolidation may prove necessary to preserve macroeconomic stability. Under such a scenario, they recommended that additional spending be prioritized and targeted. Directors noted that medium-term fiscal consolidation should be mindful of evolving public spending priorities. In addition, they recommended increasing fiscal policy countercyclicality, enhancing public project management, and advancing institutional reforms. Directors commended Estonia’s adherence to the SDDS-plus standard.

Directors welcomed the resilience of the financial sector and stressed the importance of closely monitoring new risks created by the war in Ukraine and from potential cyberattacks. Given the upward momentum in house prices, Directors welcomed the tightening of the macroprudential policy stance and highlighted the need to continually assess housing market conditions. While commending recent supervisory and legislative reforms to strengthen the AML/CFT framework, Directors called for further scaling up the capacity and powers of AML/CFT supervisors.

Directors emphasized the importance of reinvigorating structural reforms to promote dynamic and inclusive growth, including through active labor market policies and efforts to integrate refugees. Noting that Estonia’s social policies have effectively kept inequality on a declining path, Directors encouraged further actions to address social gaps that could be exacerbated by high food and energy prices. They also called for further efforts to ensure energy security and for accelerating the green and digital transitions.

It is expected that the next Article IV consultation with the Republic of Estonia will be held on the standard 12-month cycle.