Council opinion of 10 March 2009 on the updated convergence programme of Estonia, 2008-2012
Date: 2009-03-10
Institutions: Council of the European Union
Subjects: Estonia, budget estimate, economic convergence, economic forecasting, public finance, stability programme

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Official Journal of the European Union

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COUNCIL OPINION

of 10 March 2009

on the updated convergence programme of Estonia, 2008-2012

(2009/C 63/02)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveil-
lance of budgetary positions and the surveillance and coordination of economic policies (1), and in particular
Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

(3)

On 10 March 2009, the Council examined the updated convergence programme of Estonia, which
covers the period 2008 to 2012.

The Estonian economy is currently experiencing a severe downturn. During 2008 several external
factors, notably the deepening global
financial crisis and weakening external demand, while
supporting a moderation of external and internal imbalances, added to the ongoing adjustment in
domestic demand and contributed to speeding up the contraction of the economy. Wage growth far
in excess of productivity growth, including in the public sector, contributed to the loss of cost compe-
titiveness during the previous years of high growth, and the adjustment of the labour market to the
downturn was lagged. However, wage moderation appears to have taken hold since the end of 2008.
In the context of the currency board framework, monetary and credit conditions tightened in 2008
amid higher country risk perceptions and a continued appreciation of the real effective exchange rate.
Public finances have deteriorated markedly after six years of nominal surpluses, with an expected
deficit of around 2 % of GDP in 2008 and an expected further deterioration in 2009 and 2010.
Given the adjustment needs stemming from the country's imbalances, the authorities envisage fiscal
consolidation in order to limit fiscal deterioration, facilitate the adjustment process and help maintain
market confidence.

The macro-economic scenario underlying the programme estimates real GDP to have declined by
2,2 % in 2008 and projects a further contraction by 3,5 % in 2009. Thereafter GDP is projected to
recover to 2,6 % growth in 2010 and average annual growth of 4,9 % in 2011 and 2012. Assessed
against currently available information (2), this scenario is based on favourable growth assumptions
for 2009 and 2010, reflecting an optimistic assessment of export market growth and not fully taking
into account more recent information pointing to a further deterioration in economic and confidence
indicators. The programme's projections for inflation appear realistic and the fall in domestic demand
and global market developments may exert further downward pressure on prices. The external
balance is set to improve in the programme's scenario at a somewhat lower rate than in the Commis-
sion services' January 2009 interim forecast, due to more favourable expectations regarding domestic
demand and different external price assumptions.

(1) OJ L 209, 2.8.1997, p. 1. The documents referred to in this text can be found at the following website:

http://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

(2) The assessment notably takes into account the Commission services' January 2009 interim forecast, but also other infor-

mation that has become available since then.

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(4)

(5)

(6)

(7)

(8)

(9)

For 2008, the general government deficit is estimated at 2,0 % of GDP in the Commission services'
January 2009 interim forecast, against a target of a surplus of 1,3 % of GDP set in the previous
update of the convergence programme. The deterioration reflects most notably a marked fall
in
revenue compared with the initial estimates due to a considerable worsening of the macro-economic
situation compared with projections in the previous update of the convergence programme. The dete-
rioration in revenue was to some extent offset by lower expenditure compared with the previous
target following the adoption in mid-2008 of a restrictive supplementary budget with broad-based
expenditure cuts.

The target for the general government balance in 2009 is a deficit of 1,7 % of GDP, which compares
with a deficit projection of 3,2 % of GDP in the Commission services' January interim forecast. Fiscal
policy in the short term is geared towards restoring market confidence and limiting the divergence
from the Treaty reference value, given the authorities' euro adoption objective. Expenditure growth in
the original 2009 budget was expected to exceed nominal GDP growth,
in particular due to an
increase in pensions as a result of the indexation formula in force. The adoption of a supplementary
restrictive budget in February 2009 targets to bring expenditure growth broadly in line with the
projected nominal economic growth. The budgetary strategy for 2009 also comprises some revenue-
increasing measures and postponement until 2010 of previously planned tax cuts. Overall, the 2009
fiscal stance as measured by the change in the structural (cyclically-adjusted net of one-off and other
temporary measures) balance is expected to be restrictive,
including the supplementary budget
adopted in February 2009 providing for fiscal tightening above 3 % of GDP in 2009 according to the
estimates of the national authorities.

The medium-term budgetary strategy of the programme is to achieve a structural surplus, thus overa-
chieving the current medium-term objective (MTO), defined as a balanced budget in structural
terms (1). The general government headline deficit is expected to narrow to 1,0 % of GDP in 2010
and to turn to surpluses of 0,1 % of GDP in 2011 and 0,2 % of GDP in 2012. The adjustment is
foreseen to be expenditure-based with expenditure growth (underpinned by unspecified measures)
below that of nominal GDP in all years starting from 2010. Revenue growth is set to recover partially
following the turnaround of the economy, taking into account tax cuts foreseen by existing legislation
for 2010-2012.

The budgetary outcomes are subject to downside risks, in particular for 2009 and 2010, as the
macro-economic scenario is based on favourable growth assumptions. However, the risks are miti-
gated by the recent adoption of a supplementary restrictive budget. The projected return of the
general government deficit to a surplus from 2011 onwards may also prove challenging, taking into
account the programme's lack of information as regards the measures underpinning the expenditure-
based fiscal consolidation.

The long-term budgetary impact of ageing is among the lowest in the EU and should remain so
according to the programme, even taking into account the effect of the recent change in the pension
indexation rule. The current level of gross debt is very low in Estonia and maintaining sound govern-
ment finances, in line with the budgetary plans over the programme period, would contribute to
limiting the risks to the long-term sustainability of public finances, which are currently at low level.

The budgetary framework is based on a rule of ex ante nominal balance or surplus of the general
government. Although the rule does not have any legal underpinning, it has normally been respected
in the years prior to the current downturn. In recent years, the government has adapted the imple-
mentation of the rule by better taking into account cyclical conditions of the economy, as some
budgets at the peak of the cycle have been adopted with ex ante surpluses. However, the expenditure
planning framework remains weak, as initial expenditure targets have systematically been raised in
supplementary budgets, facilitated by higher-than-expected revenue in previous good economic times.
Strengthening the medium-term expenditure framework and increasing expenditure efficiency there-
fore becomes particularly important in the current economic downturn and would help in mitigating
the impact of less buoyant revenue on public finances. According to the convergence programme, the
government intends to move towards performance and accrual-based budgeting, initially in the form
of pilot projects, with a view to strengthening the medium-term budgeting process.

(1) The government has announced that it will revise and specify the MTO implying a surplus in structural terms.

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(10) With a view to stabilising the financial sector, the Estonian authorities have increased the deposit
guarantee coverage from the kroon equivalent of EUR 20 000 to EUR 50 000 and extended the
deposit guarantee ratio to 100 %, both with effect from 9 October 2008. In addition, a package of
legislative proposals to make crisis management more flexible, including by establishing fast-track
procedure for State intervention, was submitted to Parliament in December 2008.

(11)

(12)

In line with the European Economic Recovery Plan (EERP) agreed in December 2008 by the European
Council, Estonia, as a country facing significant external and internal
imbalances, has aimed its
budgetary policy at correcting such imbalances. Taking also into account risks to the budgetary
outcome and the difficulty in securing new financing at acceptable conditions due to market risk
aversion, the overall restrictive fiscal stance planned in 2009 and 2010 is thus an adequate response.
In the context of the National Reform Programme, the Estonian authorities have enacted a number of
structural reforms with neutral or limited short-term budgetary impact, in particular measures to
support labour market and investment, while there has been less emphasis on measures that support
industrial sectors and household purchasing power. Two measures to support the labour market are
the adoption of the modernised Labour Law and an ongoing reform of the Public Service Law to
raise the flexibility in the market, while increasing unemployment benefit rates and broadening the
range of beneficiaries to enhance security. These measures are related to the medium-term reform
agenda and the country-specific recommendation proposed by the Commission on 28 January 2009
under the Lisbon Strategy for Growth and Jobs.

The fiscal stance is expected to be restrictive in 2009-2011 and to turn mildly expansionary in 2012.
Although the safety margin against normal cyclical fluctuations is respected in all years starting
from 2009, this may become insufficient, due to the severe downturn, to prevent breaching the 3 %
threshold in 2009 and 2010. However, the risks to the budgetary outcome are mitigated by the adop-
tion of the supplementary restrictive budget in February 2009. Taking into account risks, the planned
return to surplus may also not be achieved in 2011, as projected in the programme. Moreover, the
adjustment should be backed by measures. In the context of Estonia's ERM II membership and the
need to improve the economy's cost competitiveness, correction of previously high wage growth
would be warranted.

(13) As regards the data requirements specified in the code of conduct for stability and convergence

programmes, the programme has some gaps in the required and optional data (1).

The overall conclusion is that Estonia, while facing a severe economic downturn following years of above-
potential economic growth, is planning a restrictive fiscal stance from 2009 until 2011 which is an appro-
priate response in light of the existing imbalances. The economic downturn is being aggravated by the
global financial crisis and subdued external demand. Weakened cost competitiveness, in particular due to the
prolonged period of wage growth above that of productivity, also hinders the return to a sustainable growth
path. The general government balance deteriorated considerably in 2008 and turned to deficit, following six
years of surpluses. According to the programme the general government is expected to be in deficit also
in 2009 and 2010, with the deficit gradually declining. Taking into account macro-economic risks and the
lack of information on expenditure-based consolidation in 2010, the budgetary outcomes are subject to
downside risks, with the headline deficit possibly exceeding the 3 % threshold in 2009 and 2010. However,
the risks to the budgetary outcome are mitigated by the adoption of the supplementary restrictive budget in
February 2009.

In view of the above assessment and also given the need to ensure sustainable convergence and a smooth
participation in ERM II, Estonia is invited to:

(i) implement the consolidation of public finances in the short term, ensure keeping the general govern-
ment deficit below 3 % of GDP and take necessary measures to underpin the consolidation in the
medium term;

(ii) implement prudent public sector wage policies to support the adjustment of the economy and to

strengthen competitiveness;

(iii) reinforce the medium-term budgetary framework, particularly by improving expenditure planning and

efficiency.

(1) In particular, nominal effective exchange rate assumptions are missing. In addition, assumptions for euro area interest rates

are used, although this can be justified by the absence of sufficiently representative EEK interest rate indicators.

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Comparison of key macro-economic and budgetary projections

2007

2008

2009

2010

2011

2012

Real GDP
(% change)

HICP inflation
(%)

Output gap (1)
(% of potential GDP)

Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

General government
revenue
(% of GDP)

General government
expenditure
(% of GDP)

General government
balance
(% of GDP)

Primary balance
(% of GDP)

Cyclically-adjusted
balance (1)
(% of GDP)

CP Nov 2008

COM Jan 2009

CP Nov 2007

CP Nov 2008

COM Jan 2009

CP Nov 2007

CP Nov 2008

COM Jan 2009 (2)

CP Nov 2007

6,3

6,3

7,4

6,7

6,7

6,6

8,0

9,0

2,7

– 2,2

– 3,5

– 2,4

– 4,7

2,6

1,2

6,7

2,8

2,7

3,6

4,8

n.a.

7,0

3,0

n.a.

3,5

5,0

n.a.

n.a.

3,2

n.a.

n.a.

6,1

4,2

3,2

5,6

– 5,7

– 5,9

– 3,9

– 1,7

– 5,4

– 6,4

n.a.

– 1,2

– 1,5

– 1,3

n.a.

n.a.

5,2

10,6

10,6

8,6

0,9

2,1

0,1

CP Nov 2008

– 16,9

– 10,5

– 5,1

– 5,0

– 4,7

– 4,7

COM Jan 2009

– 17,1

– 8,8

– 4,2

– 2,6

n.a.

CP Nov 2007

– 14,0

– 9,9

– 8,2

– 7,8

– 7,4

n.a.

n.a.

CP Nov 2008

38,2

36,2

38,9

37,8

36,5

35,2

COM Jan 2009

38,2

36,5

38,2

38,4

n.a.

CP Nov 2007

37,2

38,2

38,2

37,4

36,3

n.a.

n.a.

CP Nov 2008

35,5

38,2

40,6

38,8

36,4

35,0

COM Jan 2009

35,5

38,5

41,4

41,6

n.a.

CP Nov 2007

34,6

36,9

37,2

36,5

35,5

CP Nov 2008

COM Jan 2009

CP Nov 2007

CP Nov 2008

COM Jan 2009

CP Nov 2007

CP Nov 2008

2,7

2,7

2,6

2,9

2,9

2,7

0,3

– 1,9

– 1,7

– 1,0

0,1

– 2,0

– 3,2

– 3,2

n.a.

1,3

1,0

0,9

– 1,8

– 1,5

– 0,8

0,8

0,3

– 1,8

– 3,0

– 2,9

n.a.

1,4

– 2,2

1,1

0,0

1,0

0,8

0,8

1,3

COM Jan 2009

– 0,1

– 2,6

– 1,6

– 1,3

n.a.

CP Nov 2007

1,8

1,3

1,4

1,3

1,2

n.a.

n.a.

0,2

n.a.

n.a.

0,4

n.a.

n.a.

0,7

n.a.

n.a.

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2007

2008

2009

2010

2011

2012

Structural balance (3)
(% of GDP)

CP Nov 2008

– 0,1

– 2,4

– 0,1

0,4

COM Jan 2009

– 0,4

– 2,8

– 1,6

– 1,3

Government gross debt
(% of GDP)

CP Nov 2007

CP Nov 2008

COM Jan 2009

CP Nov 2007

1,2

3,5

3,5

2,7

0,8

3,7

4,3

2,3

1,4

3,7

6,1

2,0

1,3

3,5

7,6

1,8

1,2

n.a.

1,2

3,0

n.a.

1,6

0,7

n.a.

n.a.

2,8

n.a.

n.a.

Notes:
(1) Output gaps and cyclically-adjusted balances from the programmes as recalculated by Commission services on the basis of the informa-

tion in the programmes.

(2) Based on estimated potential growth of 4,6 %, 4,1 %, 3,7 % and 3,5 % respectively in the period 2007-2010.
(3) Cyclically-adjusted balance excluding one-offs and other temporary measures. One-offs and other temporary measures are 0,4 % of
GDP in 2007, 0,2 % in 2008, 0,1 % in 2009, 0,4 % in 2010 and 0,1 % in 2011; all deficit-reducing according to the most recent
programme. One-offs for the period 2009-2011 are not considered to be of a one-off nature according to the Commission services'
January interim forecast.

Source:
Convergence programme (CP); Commission services' January 2009 interim forecasts (COM); Commission services' calculations.