Following the year of two elections in 2019 — general and the European Parliament — 2020 might look relatively quiet in Estonian politics, but that would be a misleading assumption. Although there are no elections scheduled in Estonia in 2020, the political scene will remain turbulent.
The ruling coalition of the Centre Party, led by Prime Minister Juri Ratas, and the far-right Conservative People’s Party of Estonia (EKRE), is a fraught arrangement. Ratas broke the political consensus of mainstream parties of keeping EKRE out of power and struck a political deal with the far-right in April, only to see his coalition partner’s ministers embroiled in scandals shortly afterwards. Between April and November, three EKRE ministers were forced to resign over accusations of domestic violence, misleading the parliament, and conflict of interest.
EKRE’s Interior Minister Mart Helme also caused uproar in December by mocking the new Finnish Prime Minister Sanna Marin and calling her a “sales girl”. That prompted an apology by President Kersti Kaljulaid.
Similarly to other right-wing populists that have gained in popularity in the European Union recently, EKRE is a Eurosceptic party fiercely opposed to immigration. That runs counter to the long-standing consensus in Estonian politics of unwavering support for the EU and cooperation within the bloc.
Current polls give the opposition centrist Reform Party 34%, well ahead of Ratas’ Centre Party at 21% and EKRE at 15%. Social democrats from SDE are at 11% while the liberal Estonia 200 is at 7%.
Aside from tensions in the parliament brought on by EKRE, 2020 is likely to see some build up ahead of next year’s presidential election. Kaljulaid is all but certain to run for second term. She will be supported by the Reform Party. There is no word of any counter candidates yet. In Estonia, the president is elected by members of the parliament.
Growth slowdown looms
Estonian economic growth fared above expectations in 2019, with GDP accelerating to above 4% y/y in the third quarter, according to the most recent available data. Based on the better performance in the first three quarters of the year, there followed upward revisions of growth in 2019.
But as the outlook for 2019 improved, there also appears to be a consensus that the small, open, and vulnerable to external tensions Estonian economy will clearly ease its growth rate in 2020.
Growth is expected at 2-2.3% this year, on the back of the dampening effect of faltering exports — that, in turn, being an effect of the downturn in global trade, including the decline in Nordic real estate markets, forecast to exert a negative impact on construction-related exports.
While investment growth surprised to the upside in 2019, it is not a given that the trend of strong growth in investment will hold. “In a small economy, it is difficult to predict capital spending, but changes in demographics and developments in sentiment indicators make it difficult to assume that the recent strong trend can continue,” SEB wrote.
What appears relatively certain is the continued strength of consumer spending, the main factor behind growth in recent years. Consumption is forecast to remain healthy on the back of employment growth and rising wages in 2020, although it is expected to weaken somewhat — expanding 2.8% compared to 3.5% in 2019 — as is the economy as a whole.
“The economy cannot run at full power for a long time without losing competitiveness since rising wage costs will force companies to raise prices. It is notable that the assessment of companies of their own competitiveness has already started to deteriorate,” Estonia’s central bank, Eesti Pank, wrote in December.
Sector-wise, the largest contributor to GDP expansion in 2019 was the information and communications technology (ICT) sector, the main driver of economic growth for a decade now. There is little to indicate that will change in 2020 as Tallinn is determined to maintain its position of a tech-savvy nation, although it is going to find itself in competition with Baltic neighbours Latvia and especially Lithuania, which have also recognised the power of tech innovation.
Estonian inflation is expected to decelerate in 2020 to slightly above 2%, with SEB forecasting price growth of 2%, the European Commission 2.1%, and the Estonian government assuming 2.2% in the 2020 budget bill.
The labour market will remain largely unchanged in 2020, although the unemployment rate is forecast to rise slightly to 5.2-5.8%. “Should manufacturers be hit by a strong headwind in 2020, companies will be more likely to reduce their number of employees. However, we believe that a rapid increase in unemployment is not so likely, since many companies still seem willing to hire,” according to SEB.
“Unemployment will rise in the coming years as the economy will cool, while more people than before will enter the labour market but not all of them will find work. Labour market activity will be increased by the gradual rise in the retirement age, improving health, and the general growth in the level of wages, which encourages people to work,” predicted Eesti Pank in December.
Government debt to rise
The Estonian parliament approved the 2020 budget bill in December. The bill assumes revenues of €11.8bn, an increase of 6.9% versus 2019. The state’s expenses are set to come in at €11.6bn, a growth of 2.1% over 2019.
“The draft budget for 2020 is in nominal balance and moving structurally towards a balance, with a structural deficit of 0.7 per cent of GDP,” according to the government.
The government sector's debt burden is to decrease both in euros and as a share of GDP, according to the budget bill. While the debt burden was 8.8% of GDP in 2019, it will compress slightly to 8% of GDP in 2020. In absolute terms, that means a reduction to €2.4bn in 2020, compared to €2.3bn in 2019.
The 2020 budget bill assumes an increase in pensions, the Health Insurance Funds, research and development, as well as defence. Defence spending will once again reach the Nato-proposed level of at least 2% of GDP, something that many other alliance members have struggled with. Estonia is, however, wary of meeting its Nato commitments because of its proximity to Russia, seen as a hostile country.
The budget bill also penciled in pay rises for public sector employees such as teachers or social workers.
The budget bill for 2020 is also the first bill with a new structure. “The previous budget [was] described in terms of expenditure [while the 2020] state budget will consist of programmes led by ministers. This means that the government sets performance targets for the programmes and, to achieve them, state authorities are to provide services of agreed quality, volume and cost,” Estonian newspaper Postimees reported in December.
The budget bill comes on the back of macroeconomic assumptions of GDP growth of 2.2% in 2020 and inflation easing to 2.2% as well.
Successive Estonian governments have followed a balanced budget policy. Financial reserves have accumulated, and the amount of outstanding debt obligations remained relatively low.
In the 2020 budget bill, debt is expected to come in at just 8% of GDP, over 13pp behind the next least indebted country, Bulgaria.
At the end of June 2019, the liquidity reserve was 1.2 times larger than the amount of outstanding debt obligations, which consisted of two loans from the European Investment Bank (EIB) and two Treasury bills, according to the most recent update from the Ministry of Finance from August.
“Although the State Treasury is not active in debt management, it has to be ready to borrow quickly if needed – it has in place several committed credit lines with banks that can quickly be drawn upon in case of need to safeguard the state’s ability to make payments,” according to the ministry.
“Based on the state’s limited funding needs, it has been more favourable to take long-term investment loans from the European Investment Bank and other [international financial institutions] IFIs than to issue bonds. EIB and other IFIs loan facilities typically have flexible and favourable terms and conditions, e.g. no fees, a long drawdown period, possibility to choose between different repayment terms up to 25 years, favourable interest rates and rights to make partial or full prepayment,” according to the ministry.
Estonia’s debt rating is at AA- with stable outlook (Fitch, last updated in October 2018), AA- with stable outlook (S&P, last updated in October 2012) and A1 with stable outlook (Moody’s, last updated in March 2010).
Banks in the spotlight — for all the wrong reasons
Estonia’s banking sector found itself in the global spotlight in 2019 over allegations of mass-scale money laundering raised against the Estonian branches of Danske Bank and Swedbank. The aftermath of the allegations is likely to reverberate throughout 2020.
Danske Bank, which was accused of handling up to €200bn of possibly illicit money flows between 2007 and 2015, has since closed its operations in Estonia.
Meanwhile, Swedbank is being probed by authorities in the US, Sweden, and the Baltic states over its handling of billions of euros’ worth of suspicious transactions, including from non-resident clients based in Russia. The shady transactions flowed between 2010 and 2016, it was alleged.
The Danske Bank and Swedbank cases are likely to spur reforms in the Eurozone, of which Estonia has been a member since 2011, to tighten control of money flows into the EU. Specifically for Estonia, those cases mean a tarnished reputation that Tallinn will — or at least should — be keen to amend in 2020.
Still, the latest financial stability review from Eesti Pank indicated in November that risks to the financial sector are small. “The probability has increased though of the cooling economy making it harder for businesses to make their loan payments,” the central bank said, however.
The slowdown in economic growth could impact the Estonian real estate sector. “The share of loans to the real estate sector that turned bad in the last economic crisis was double that in other sectors. The risk may be amplified because real estate loans are such a large part of the loan portfolio of the banks,” according to Eesti Pank.
Another risk is that of spillover of economic slowdown in Sweden, as Swedish banks are major lenders in Estonia. Still another is Estonians, who have enjoyed a rapid wage growth in recent years, borrowing too much to be able to repay comfortably once the slowdown hits.
Eesti Pank is maintaining the countercyclical buffer requirement for the banks at 0% as the debt to income ratio of the non-financial sector has not increased. The central bank forecasts that the rate of growth of bank loans should be similar to the nominal rate of GDP growth in the coming years, and no developments or trends in bank behaviour are in view that would amplify lending activity.
The capitalisation of the banks operating in Estonia has remained strong, underpinned by the capital buffer requirements introduced by Eesti Pank. Banks operating in Estonia have to hold a systemic risk buffer of 1% to mitigate the risks of a sudden slowdown in the economy. The three systemically important banks, Swedbank, SEB, and Luminor, have to hold a further buffer of 2% to hedge against the risks that come from the concentration of the banking sector.
Estonia’s banking sector made €73mn in pre-tax income in the third quarter, a drop of 8% y/y, Eesti Pank said in October. Higher administrative costs ate into the profit, while there also was a reduction in revenue from service fees. “As the banking sector has seen rapid growth in assets at the same time, by €4bn to €29bn, the combined impact of lower income and increasing assets has reduced the return on assets of the sector,” Eesti Pank said.
The rapid growth in the assets of the banking sector was affected very much by Luminor Bank, which brought its Latvian and Lithuanian units under its Estonian headquarters as branches, the central bank also noted.