Country Report Estonia
Estonia’s economic growth will moderate this year, but due to the turmoil in Ukraine the risks are tilted to the downside. Meanwhile, Estonia’s fiscal position remains strong.
Strengths (+) and weaknesses (-)
(+) Track record of fiscal prudence
Estonia has been maintaining prudent fiscal policies that have resulted in a low public debt level of 10% of GDP. The fiscal balance has not shown a deficit larger than 3% of GDP in the past decade and has regularly posted a surplus.
(+) Attractive business environment
The business environment in Estonia is generally considered to be attractive with low corporate tax rates and business-friendly policies, especially with regards to foreign investment and foreign trade. The World Bank ranks the country 22nd (out of 185) in its Ease of Doing Business index.
(-) High level of foreign debt
Estonia’s total external debt of Estonia amounts to more than 95% of GDP, of which about 29% is short-term debt. The country’s entry into the eurozone in January 2011 has mitigated part of the related risk as a substantial part of the foreign debt is denominated in euros.
(-) Ageing population
As a result of ageing and emigration Estonian working population is expected to decline in the coming years. This will put a drag on economic growth and increase health care costs.
1. Estonia’s economic growth slows
Estonia’s economic growth decelerated sharply to 0.8% in 2013, from 3.9% in 2012. A small bright spot was the fact that economic conditions improved slightly throughout the year. In 2013 as a whole, growth was driven by a rise in gross fixed investment as well as an increase of private and public consumption. Private consumption rose on the back of higher household spending on recreation, culture and food items. Net exports contributed negatively, as imports grew faster than exports (figure 1). The deceleration of exports was the result of weaker demand from several of Estonia’s export markets, which include Sweden, Finland and Russia.
In 2014, the economy is expected to growth by around 3.0% on the back of rising investment and private consumption. The growth of private consumption will be supported by a rise in real wages. However, the risks are mainly tilted to the downside. First, turmoil in Ukraine and Russia is likely to have a negative economic impact on these countries, which may lower demand for Estonian goods. Currently Russia is one of Estonia’s main trading partners (figure2). Besides, the Ukraine-Russia turmoil has led to EU sanctions against Russia. In a worst case scenario this may trigger tit-for-tat sanctions, whereby Estonia could lose an important source of gas supply. Second, if the expected rise of real wages is not accompanied by similarly large productivity gains, Estonians’ international competitiveness will suffer.
2. Border dispute with Russia finally solved
After 20 years of talks, Russia and Estonia signed a border treaty on 18 February 2014. The treaty includes three agreements. On the border, 128.6 hectares of land and 11.4 square kilometers of lake will be exchanged. Currently, three Estonian villages can only be reached from Värska through a detour of 15-20 kilometers or by passing a one kilometer long road on Russian territory. People were, however, not allowed to pass the road on foot. In addition, Estonia will hand over part of the Narva reservoir to Russia. The third agreement refers to the conditions regarding the location of the Estonian embassy in Russia and the Russian embassy in Estonia. The treaty must still be ratified by both parliaments, and will come into effect 30 days thereafter. After the treaty was signed, Russian Foreign Minister Sergei Lavrov said "I am sure this will strengthen the atmosphere of trust and cooperation."
3. Ukraine-Russia dispute
The Ukraine-Russia turmoil over Crimea has made the Baltic states, including Estonia, nervous. Especially since Russia has defended the annexation of Crimea by arguing that it has the right to protect Russian-speakers outside its borders. Currently some 25% of Estonia’s population is ethnic Russian, whereby the ethnic Russian population is highly concentrated in the northeast of Estonia (figure 3). In addition, Russia has been arguing that the rights of ethnic Russians in the Baltics are being undermined. Whether the sovereignty of Estonia is really at risk is very difficult to judge. In the regard we note that Estonia has two important assets which Ukraine does not have; it is a member of both NATO and the eurozone. This implies that Russia risks considerably more in case it invades Estonia, such as military conflict and tougher economic sanctions. But, even if Russia does not infringe the sovereignty of Estonia, Russia may still use its soft powers, as it has done in Lithuania recently. There Russia frustrated the exports of Lithuanian goods to Russia. Similar measures towards Estonia would negatively impact the Estonian economy.
4. Resignation of Andrus Ansip
Estonian prime minister Andrus Ansip (Reform Party) announced his resignation on 4 March 2014. Most important reason behind his resignation was to give his intended successor, Siim Kallas from the same political party, the opportunity to regain support. New elections will be held in 2015. The likelihood that policies will change significantly under Kallas is small.
Estonia is the most northern of the three Baltic States. Formerly a Soviet state, the small country has made a rapid transition to a market economy since independence in 1991. In 2004, Estonia joined the European Union and in January 2011 it became a member of the eurozone. Estonia’s economy is open and well developed with a large services sector, which accounts for about two-thirds of GDP. The economy has been moving from labor-intensive sectors, such as the garment sector, to more high-tech sectors.
Telecom, transport and tourism are key sectors for Estonia. The transport sector benefits from the fact that Estonia’s harbors remain ice-free throughout the year and therefore have a competitive edge over the Russian ports. While the EU has become Estonia’s largest trade partner since the end of the soviet era, Russia remains important as well. The relationship with Russia remains troublesome, though. Estonia has a rather substantial ethnic Russian community.
The last elections in Estonia were won by a center-right coalition, consisting of the Reform Party and the Pro Patria-Res Publica Union (IRL). The next elections are due in March 2015. Even though Estonia has a history of frequent government changes, there is a broad consensus across the political spectrum on the pro-market and pro-EU policy direction. This has resulted in a swift adoption of the euro. When Estonia became a member of the eurozone, the European Central Bank (ECB) became the monetary authority of the country. A share of Estonia’s foreign exchange (FX) reserves has been transferred to Frankfurt and the part of the FX reserves denominated in euros is no longer classified as ‘foreign’ currency. As a result, total FX reserves dropped from USD 2.5bn in 2010 to USD 0.2bn in 2011.