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  Basic statistics of Estonia, 2009
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  Executive summary
  Estonia continues to show a remarkable determination in policy making. It has established a business friendly regulation, avoided fiscal deterioration during the crisis and made it into the euro area, despite being hit by an accumulation of negative external shocks. Helped by strengthening foreign demand and increased competitiveness the Estonian economy is recovering from a deep recession, which drove the unemployment rate up to nearly 20% and left an overhang of private-sector debt. The main policy challenges are now to: avoid cyclical unemployment becoming structural; strengthen the fiscal framework; improve the framework of bankruptcy procedures to deal with non-performing loans; reap efficiency gains in government operations; and make more out of globalisation as a sustainable driver of growth.
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  Assessment and recommendations
  The Estonian economy went through an extreme cycle of record-breaking growth up to 2007 and a precipitous decline in 2008 and 2009. Boosted by foreign demand and increased competitiveness, the economy has bottomed out, and is now generating some growth again. Unemployment is still high but positive inflation has already returned after a short interval of mild deflation. Unsustainable current account deficits have been corrected, although this improvement has not yet been tested by a solid recovery of domestic demand. This Survey focuses on the legacy of this major recession and the challenges going forward in the form of: the risk of a steep increase in structural unemployment; a high level of non-performing loans; the macroeconomic policy challenge of avoiding another boom-bust cycle in the course of euro adoption; securing the efficient use of public resources; and making the most out of globalisation. In order to keep the economy on a sustainable growth path in the future, work should be carried out towards developing new macro-prudential tools tailored to Estonia’s small open economy so as to better deal with a situation of excessive credit growth.
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  Emerging from the recession
  In the wake of an enormous boom and bust cycle, Estonia faces the challenge of ensuring the nascent recovery that began at the end of 2009 broadens out into a sustainable return to high growth rates. Such a return cannot be taken for granted, not least because the economy faces significant restructuring challenges following the construction bust. Households need to deleverage, bad debts wait to be dealt with and policy has an important role to play in fostering a return to high growth rates. This will require Estonia to tackle the significant fallout from the severe recession, including a marked rise in non-performing loans and high unemployment. If not dealt with adequately these factors may respectively impede credit growth and result in a permanently higher rate of unemployment that would undermine the recovery. Progress is being made in resolving non-performing loans but procedures are overly expensive, slow and bureaucratic. Estonia’s labour market is flexible but serious skills and jobs mismatches threaten to make the large increase in unemployment structural. It will be important to continue improving and expanding training tailored to individual needs as well as the efficiency of the public employment service’s job matching capacity. Labour tax cuts targeted to the low-paid would help to boost labour demand for those whose skills will be difficult to upgrade quickly. Once established, maintaining high growth path will require improving macroeconomic management tools to deal better with the hazards of irrational exuberance and excessive credit growth.
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  Fiscal policy: Avoiding pro-cyclicality and safeguarding sustainability
  Public finances came under severe strain during the economic crisis, but the remarkable fiscal consolidation implemented during 2009 averted a confidence crisis and paved the country’s way into the euro area. The large-scale fiscal adjustment of about 9% of GDP included significant structural measures, but also sizeable one-off and temporary measures, including the diversion of state contributions to the mandatory funded second pension pillar to the general government budget. Fiscal policy is now confronted with three overlapping challenges: establishing a new balance between revenues and expenditure to ensure a durable improvement in the underlying fiscal position; protecting fiscal balances in the upswing; and preventing an erosion of contributions to the second pension pillar. The last is particularly important for preserving long-term fiscal sustainability. To address these challenges, fiscal rules and institutions need to be strengthened. The tax system can be enhanced to support fiscal consolidation and improve efficiency, while preserving the simplicity and transparency of the Estonian tax system. There is scope to raise the share of the least distorting property and environmental taxes. The efficiency of the VAT system was weakened during the recession. Strengthening VAT administration, reconsidering exemptions and possibly increasing the standard VAT rate could be used to compensate for reductions in more distorting labour taxes.
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  Public sector spending efficiency
  The Estonian fiscal position is much better than in many OECD countries, the country stands out for having a rather lean government sector and the authorities are striving for efficient use of existing resources. Both healthcare and local government were particularly hit the by the decrease of resources as a result of the unprecedented GDP fall during the downturn. As a return to high revenue buoyancy will not be immediate, there are challenges for delivering the same with less money but it is also an opportunity to reconsider provision of public services. The healthcare sector is state dominated and offers some scope for efficiency improvements. On the supply side, further streamlining of the existing hospital network, emphasising primary care, and keeping an eye on the standard of quality of care, would be helpful. A number of market signals are already in place on the demand side, such as fees and drug co-payments. Yet these raise issues of accessibility of healthcare, in particular for financially distressed households. A cap on out-of-pocket spending together with active promotion of least expensive drugs use would help to address this issue. Local government seems rather extensive and fragmented for such a small country. Exploiting economies of scale, either by merging or requiring deeper co-operation, should bring gains in terms of public service efficiency. Offering greater scope for tax raising at the local level can incentivise the municipalities to adopt more growth-oriented economic policies.
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  Estonia: Making the most of globalisation
  Estonia has already experienced many benefits of increasing international integration, most obviously in significant convergence. From the Russian crisis in 1998 to the great recession in 2009 Estonia gained an impressive 20% relative to the EU27 average GDP per capita in PPPs. Similar to the other Baltic economies, however, a considerable part of earlier convergence gains was lost in the crisis, aggravated due to the collapse of world trade. While this was also true for Ireland, central European catching up countries like Czech Republic, Poland and Slovakia have been less affected by the crisis and could maintain most of their convergence gains. Nevertheless, prior to the recession Estonia’s gap in income and productivity levels compared with the EU average were still around 30% and as the country emerges from recession it faces major policy challenges to maintain its pre-crisis rate of growth potential. The greater focus on closing the productivity gap in manufacturing-for-exports of other transition countries may serve as an interesting benchmark in order to get more out of globalisation.
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  Glossary
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