“Like other countries in the region, Estonia has been severely affected by the world financial crisis. We presently project output to contract by 13 percent this year and the recovery to start in late 2010 at the earliest, depending in part on global developments. Imbalances built up in the boom years are correcting quickly, with the external current account deficit expected to largely close and inflation to move below the Maastricht reference level already this year. The drop in nominal wages after the very strong growth over the past years, while painful, will bolster Estonia’s competitiveness and is a testament to the economy’s flexibility and commitment to its currency peg.

”The financial system operating in the environment of Estonia’s successful currency board arrangement has proven resilient to the deterioration of global funding conditions. Banks can look to large liquidity buffers, recently enhanced by the precautionary swap arrangement between Eesti Pank and the Swedish Riksbank. The close integration with Nordic parents, which have maintained their exposure throughout the crisis, proves to be a strength for both the financial and corporate sector. Nevertheless, in this uncertain environment financial flows and capital adequacy need to be monitored closely.

“The major policy challenge, for 2009 and beyond, is the budget. Prudent fiscal policies for most of the decade have allowed for the accumulation of reserves, but these are now eroding quickly as tax revenues suffer from the sharp economic downturn. Spending increases, pension and wage hikes in 2007-08 are proving unsustainable, especially because growth will likely be permanently lower than during the post-EU accession years. This calls for a fundamental rebalancing of fiscal expenditures and revenues.

”In this context, the authorities’ deficit target of below 3 percent of GDP appears appropriate. This reflects both the size of remaining fiscal buffers and uncertainty about future financing possibilities given present financial market conditions. It will also help Estonia to qualify for speedy euro adoption—a goal to which the authorities rightly attach high priority. Reducing the deficit to such a level already in 2009-10, however, will be very challenging against the backdrop of the unprecedented economic downturn. Given the uncertain outlook, all options—on both the revenue and the expenditure side—should be considered.

It will be important to identify measures that limit the procyclical impact on growth, preserve the social safety net, and have a permanent effect on the fiscal balance.“