Estonia faces a difficult path back to fiscal balance after more than doubling defence spending in response to Russia's invasion of Ukraine, with the burden of higher security costs adding to strains already created by the pandemic and energy crisis, Finance Minister Jürgen Ligi said in an interview with IntelliNews.

The Baltic state, one of Nato's most vocal advocates for stronger defence, has increased military expenditure from just over 2% of GDP before the war to around 5.4% now, among the highest levels in the alliance.

As well as the “political decision to raise defence expenditure”, Ligi also references “other things connected with Russian aggression — other security and social expenditure — mean there is a deficit which it is very difficult to come out of”.

While many European countries loosened fiscal policy during the COVID-19 pandemic and subsequent energy crisis, Ligi argued Estonia's public finances were already on a weaker footing before the latest geopolitical shocks.

"Fiscal discipline was lost before COVID and the energy and Ukraine events," he said. "So our public finances are the biggest concern for Estonia."

The government is aiming to reduce the budget deficit from an anticipated 4.5% of GDP this year, but Ligi acknowledged that bringing borrowing back under control would be politically difficult.

"Of course there is a plan," he said. "In August will try to make this year's planned 4.5% [deficit] smaller, and smaller next year as well, to come out of this escape clause. But to make it quick is very difficult … any talk about raising taxes will be immediately criticised. It is very complicated."

Ligi made the comments as European governments debate reforms to the European Union's fiscal framework and the use of escape clauses that allow higher spending during exceptional circumstances. While acknowledging the need for investment in structural reforms such as renewable energy, he warned against using looser fiscal rules to support measures that could prove counterproductive.

"There are structural reforms that have to be supported," he said. "But analysis shows that governments in most countries try to do things that are not helpful. In a situation of insufficient supply they try to stimulate demand, which is absolutely a wrong and counterproductive measure."

Despite the pressure on public finances, Estonia's economy has begun to recover after a sharp downturn, with first-quarter data showing the fastest growth in the European Union, although Ligi cautioned that this partly reflected the depth of the previous contraction.

He also noted there has not been a significant impact from the conflict in the Middle East, even though as a small, highly open economy, Estonia is typically vulnerable to external shocks. The economy suffered more from the energy shock caused by Russia's full-scale invasion of Ukraine. "Then came the inflationary shock. Our nominal growth was not so bad, but deducting inflation there was a decline,” he said. 

Estonia moved quickly to sever many of its economic ties with Russia after the invasion, but its proximity to the conflict and dependence on regional trade left it exposed to wider market disruptions.

"We also have very weak demand for our exports in the Nordic countries, and the devaluation of Nordic currencies made our products less competitive," he said. 

To improve the economy's resilience, the government is focusing on maintaining a competitive tax system, developing capital markets and supporting long-term investment in education and research.

The government is seeking to develop regional capital markets, and Ligi was one of the signatories to an agreement with the European Bank for Reconstruction and Development (EBRD) on deepening the pan-Baltic capital market. "We try to cooperate in this field, on infrastructure and legislation, as much as possible," he said. 

The minister highlighted Estonia's recent €1bn, 10-year sovereign bond issuance, the first conducted through the country's own financial market infrastructure and listed on the local stock exchange, as an important symbolic step.

"For the sector it is very symbolic," he said. "You have the first emission on the Estonian system, listed on the local stock exchange. It will open the doors to more capital for the Estonian stock exchange.”

Ligi noted that Estonia had managed to borrow at lower yields than France in the recent issuance, despite concerns over the country's fiscal position. "There is a lot of criticism because our debt burden is growing very fast, but it is still the lowest in Europe."

Alongside restoring fiscal stability, Estonia also faces a longer-term challenge of improving competitiveness. Ligi said productivity growth was lagging behind wage increases, creating pressure for exporters.

"We have a problem with competitiveness. Productivity is not increasing," he said. "We are digitalised in the public sector, but very weak in the private sector, in industry for example. Wages are going quicker than productivity. This is a big concern."

The government plans to launch a national artificial intelligence programme aimed at encouraging wider adoption of AI technologies and improving efficiency across both the public and private sectors. This is intended to help close the gap between Estonia's highly digitalised public sector and a private sector where productivity gains have lagged behind wage growth. Encouraging wider AI adoption, strengthening capital markets and maintaining an attractive business environment will be crucial if the economy is to generate the growth needed to support both rising security costs and fiscal consolidation.