Exports have been the main driver behind this downturn, the IMF says, reflecting weaker external demand, while private consumption has also weakened considerably, as high inflation has weighed on real disposable income.

Despite the contraction in output, labor market conditions remain tight, the IMF says.

Inflation

Inflation fell from a peak of 25 percent in August 2022, to 11.2 percent in May this year, but still remains among the highest in the euro area. Over time, inflation has become increasingly broad-based, with core inflation also rising rapidly, despite the widening negative output gap.

The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Estonia and endorsed the staff appraisal.

2023 GDP likely to be 1.6 percent below level a year earlier

During 2023, growth is expected to recover alongside only gradual disinflation. Driven by consumption and exports, growth is expected to improve during the second half of the year, but earlier weakness will leave 2023 GDP 1.6 percent below its level a year earlier.

A fiscal impulse of about 2.5 percent of GDP is expected to boost growth in the near term, the IMF says, but this will also work at cross-purposes with monetary policy, serving to counter the effect of higher interest rates on inflation, which is expected to decline only to an average of 9.7 percent in 2023.

Remarkable steps made in past 20 years, but signs of erosion there

Estonia has made remarkable progress over the past two decades, the IMF goes on, and has been achieving steady convergence towards more advanced EU economies. However, while the external position is assessed to be broadly in line with medium-term fundamentals and desirable policies, signs of erosion in external performance have emerged in recent years, reflecting rapid growth in unit labor cost and real exchange rate appreciation.

The economic effects of the war shock have exacerbated competitiveness erosion too, the IMF says.

Effects of the Russian invasion of Ukraine

Russia's invasion of Ukraine triggered a large rise in inflation, supply chain disruptions and slower growth in key trading partners in the Baltic region. In Estonia, these developments, combined with fiscal tightening in 2022, have led to a sharp economic downturn, while deceleration in productivity has further added to competitiveness pressures.

The war-initiated shock may leave some scars. A very large fiscal impulse in 2023 along with gradually stronger external demand is expected to support the recovery under the baseline but will also leave inflation well above euro area average.

In turn, high inflation is likely to exert pressure on wages which, combined with declining productivity growth, may further erode Estonia's competitive position over time.

As a result, while the economy managed to recover swiftly from the pandemic, staff project a more permanent scar from the consequences of the war over the medium term, with growth failing to return to its pre-crisis average, absent tighter fiscal policy and proactive structural reforms to support productivity.

This baseline is highly uncertain and subject to domestic downside risks. Fiscal deterioration might become entrenched, above and beyond what is already assumed under the baseline.

Too loose of a fiscal policy would undermine efforts to combat inflation

While supporting near-term growth, an excessively loose fiscal policy would undermine Estonia's dis-inflationary efforts and further weigh on its medium-term competitiveness prospects. Tighter labor market conditions, rapid wage growth triggered by generous public sector pay rises and waning productivity may exacerbate these adverse dynamics.

External downside risks are also significant. A significant tightening in global financial conditions may cripple bank credit and trigger a global recession. Major central banks could loosen monetary policy prematurely, leading to a de-anchoring of inflation expectations and increasing the risk of a wage-price spiral in Estonia's tight labor market.

An accentuation of geopolitical tensions in the region or other war-related effects may also weigh on the outlook.

IMF: Much less stimulative fiscal policy needed

Estonia's policy mix needs to be re-calibrated to support a more sustainable recovery. A much less stimulative fiscal policy should be considered.

In the near term, a neutral or - at most - an only slightly expansionary fiscal stance is needed to contain inflation.

As energy prices recede, consideration should be given to phasing out the most recent increases in family allowances while retaining targeted support to the most vulnerable groups.

Containing the expansion of the public sector wage bil - including by limiting the flexibility of line ministries and local authorities to raise wages - is critical.

Re-calibrating current spending towards productivity-enhancing capital spending would help safeguard competitiveness.

2024 tax hikes could be brought forward

Finally, the case for bringing forward some of the tax hikes envisaged from 2024 should be explored.

Over the medium-term, fiscal policy should preserve buffers to counter future shocks and spending pressures, and reaching a balanced structural budget over the forecast horizon through an improvement of about 0.5 percentage points of GDP a year, anchored in the national fiscal rule is recommended, even as it entails additional consolidation measures, including means testing social programs, saving on government operational expenditures, and a more efficient execution of capital expenditure.

Financial stability risks appear limited so far, but close vigilance is warranted amid rising interest rates.

Comprehensive and frequent bank portfolio reviews should be accompanied by rigorous stress tests, including to assess risks stemming from wholesale deposits, funding through online deposit platforms, cross-border lending, and broader spillover effects from real estate markets in the region.

Labor shortages should be addressed

Targeted structural reforms would help raise productivity, address labor market shortages, and promote the green and digital transition.

Encouraging an increase in the share of private sector R&D to a level closer to the EU average would accelerate the evolution towards higher value-added production and exports.

Addressing labor market shortages and closing skill gaps, especially in the ICT sector, would further strengthen long-term growth prospects.

Conducting a review of recently enacted social welfare reforms along with progress towards reducing the gender pay gap would support more inclusive growth.

Phasing out oil shale in energy production, introducing a car registration and road tax, and extending EU Emissions Trading System (EU ETS) coverage would support a more ambitious green transition, the IMF concludes.

The full IMF report is here.

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