Developments Since Transition Estonia regained its independence in late 1991 after half a century of central planning and dependence on trade with the countries of the former Soviet Union (FSU). At the outset of the transition, the country had the highest per capita income among any of the FSU states, and its infrastructure and education levels were among the highest. Moreover, as one of the key gateways for trade between the FSU and the West, the country had historically close ties with the Nordic countries, particularly Finland. Driven by its EU aspirations, the country has implemented a broad agenda of stabilization and structural reform policies with assistance of the International Monetary Fund, the World Bank, and other international organizations. Recent Economic PerformanceAfter EU accession in 2004, Estonia experienced a period of rapid economic growth, exceeding 10 percent in 2006. However, economic growth was driven almost entirely by domestic demand with private consumption and investment rising strongly on the back of solid income growth, rapid credit expansion and stimulus from EU funds. The labor market tightened significantly with the unemployment rate declining steadily to 4.7 percent in 2007, from over 11 percent in 2003. Both the current account deficit and inflation reached high levels, the latter seriously undermining the purchasing power of households’ income. Furthermore, much of the rapid credit expansion was in foreign exchange and banks were taking on increasing exposures to real estate, which brought substantial risks to the banks' asset quality and financial sector stability. On a positive note, given Estonia’s currency board arrangement, macroeconomic policies have focused on restrictive public finances with the government budget remaining in surplus (2.7 percent of GDP in 2007). After a period of overheating, economic growth started to slump, which together with the impact of the global financial crisis caused some concerns about Estonia’s macroeconomic stability. In 2008, Estonia faced a major economic slowdown with output growth contracting by 9.7 percent in the fourth quarter 2008. Risks to financial sector stability have increased with overheating concerns further fueled by the global financial turmoil and resulting liquidity pressures. Furthermore, concerns have been raised about contagion risks from other countries. The government is taking strong fiscal tightening measures in an attempt to keep the fiscal deficit within the Maastricht limit of 3 percent of GDP. Nevertheless, Estonia’s path of economic adjustment poses some risks for macroeconomic stability. As the expected slowdown in Estonia’s main trading partners undermines the outlook for exports, prospects of economic recovery remain bleak, with the economy set to contract substantially in 2009. Challenges AheadIn the short term, Estonia will have to weather the impact of economic recession and the global financial crisis. Strong domestic adjustment policies, including measures to regain fiscal balance, will be necessary to help unwinding the accumulated imbalances. At the same time, one of the major challenges will be protecting the most vulnerable social groups from the impact of the ongoing economic crisis. In the medium term, the overriding goal is to ensure Euro adoption as well as rapid and lasting convergence of living standards to the EU average.
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