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. 

Estonia is facing its most challenging economic situation since the early 1990s. Past overexpansion, in particular of real estate and construction, was financed by rapid credit growth, mainly via variable interest rate and foreign currency loans. Growth was in general biased towards domestic demand, fuelled also by high wage growth. Unsustainably high current-account deficits exposed Estonia to a sudden reversal of investor sentiment in the wake of the global financial crisis. The downturn has not yet bottomed out and the challenge will be to stimulate recovery and bring the economy back to potential. Macroeconomic policies have a pro-cyclical bias and the labour market has been regulated by a law which contains many elements from the Soviet era. Given the limited scope for macroeconomic policies under the currency board arrangement and low synchronisation of shocks and business cycles with those of the euro area, effective counter-cyclical fiscal policy and flexibility of the economy are crucial. The first OECD Economic Survey of Estonia addresses these issues, and focuses in particular on: i) modifying the fiscal framework to enhance the role of fiscal policy as a countercyclical tool; ii) reducing distortions in the housing market while strengthening financial stability; iii) increasing flexibility and reducing segmentation of the labour market; and iv) enhancing the business environment to foster productivity. 

The severe economic downturn and high output volatility, in the context of the currency board, underscore the importance of well-designed fiscal policies to help mitigate shocks. Since Estonia’s fiscal policy now exercises a pro-cyclical bias, the key challenge is to develop gradually its counter-cyclical role without jeopardising sustainability. The government could achieve this objective by modifying the rule of annually balanced budgets and balance the budget over the business cycle while letting the automatic stabilizers respond freely to short-term fluctuations. The deficit target accompanied by an expenditure rule incorporated in the medium term budgetary framework would facilitate sustainability and efficiency of public spending. To enhance credibility of the modified framework discretionary measures should be used for longer-term structural issues. The uncertainty of estimating the structural surplus could be addressed through a mechanism that claws back expenditure or debt overruns. An important consequence of such changes would be the development of a government bond market, which could also play a benchmark role for financial markets. 

Following EU accession Estonia experienced a loan financed boom. The boom was characterised by overinvestment in the real estate and construction sectors fuelled by strong growth in housing loans, particularly those with variable interest and denominated in foreign currency. Now these sectors are facing a downturn, which has already affected overall economic activity. Since the two sectors are closely linked, problems in one may spill over to the other. So far, risks have mostly spread from the housing market to the financial sector, as most of rapidly rising lending consisted of mortgages, which are now suffering from increasing defaults. At the same time, tighter lending conditions have dampened the demand for housing. More recently, global financial distress has led to a credit crunch and further exacerbated the downturn. At this juncture, co-operation is required between regional financial supervisory authorities to mitigate risks to financial stability as well as cyclical volatility in housing and construction. Looking ahead, financial stability could be strengthened by increasing households’ financial literacy, especially regarding the risks of high indebtedness and variable rate loans. The development of fixed rate loans could be encouraged through surveillance activity by the Bank of Estonia and/or the Financial Supervision Authority, to ensure that commercial banks are appropriately pricing credit risks. Moreover, the mortgage-based lending system accompanied by a securitization scheme should be adopted over the medium term. A careful redesign of fiscal incentives and other housing policies could bring about a better allocation of resources and increased labour mobility.

In recent years, the Estonian labour market was characterized by rising employment, declining unemployment, and skill and labour shortages that contributed to large wage increases. Labour productivity grew rapidly, but the level remains low. While the aggregate labour market outcomes improved, differences persisted among ethnic groups, regions, and workers with different skill levels. As Estonia entered recession in 2008, unemployment increased from 4% in the 2nd quarter to 7.6% in the 4th quarter, and is expected to rise further in 2009 and 2010. More flexible labour markets will be a key adjustment mechanism in the current recession as well as in the medium term if Estonia is to become a knowledge-based economy. This chapter focuses on: i) removal of barriers that hamper worker reallocation into more productive jobs; and ii) a better integration of ethnic non- Estonians and foreign workers into the labour market. 

Estonia swiftly established a modern market economy. Today, the country is considered to have one of the most open and competitive economies in the world. The dynamism of the business environment is reflected in higher rates of firm and job creation than in other European emerging market economies, as well as in large foreign direct investment inflows. Estonia is particularly well regarded in ICT network readiness and well-functioning e-government. However, the share of production in high tech and knowledge intensive sectors is relatively low, and the growth of high technology products in exports slowed down even before the recession. For Estonia to become a knowledge-based economy, its production must shift to knowledge-intensive sectors, and productivity gains from innovation will need to drive future growth. The 2007 PMR indicator confirms Estonia’s overall progress with competitionfriendly regulatory reforms. Remaining challenges should be addressed to increase the scope for competition in network industries, in particular electricity.