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Estonia: IMF Issues Praise, But Also Gives A Warning

  • Robert Lyle

Washington, 30 December 1997 (RFE/RL) -- Estonia continues to win the praises of the directors and staff of the International Monetary Fund (IMF). But the cheers are combined with stern warnings not to be caught in an Asian financial crisis of its own.

The 24 Executive Directors of the IMF, representing the institution's 181 member nations, released their annual review -- known as an Article Four consultation -- of Estonia over Christmas.

As usual, the review repeatedly called Estonia's economic performance in recent years "remarkable."

It said Estonia's relatively conservative fiscal stance and strong commitment to structural reforms "aimed at minimizing direct participation of the state in the economy" have aided the rapid development of a vibrant private sector. By mid 1997, the fund said, 75 percent of the Estonian economy was under private ownership, including the banking system, services, trade and most industry.

Real growth of the economy, as measured by the GDP or gross domestic product, increased by four percent in 1996 and by almost 12 percent during the first half of 1997, while unemployment remained stable and inflation continued to fall.

But the IMF executive directors warned that Estonia now faces problems in maintaining its macroeconomic stability because "buoyant" domestic demand, fueled by rapid growth in bank credit, has caused imports to surge. Buying so much abroad widened Estonia's current account deficit to around 10 percent of GDP in 1996. It is expected to decline, but still remain high, in 1997. Economists normally try to keep current account deficits to five percent of GDP.

This deficit of what Estonia is selling abroad compared with what it is buying is being easily covered by a continuing substantial inflow of capital, including direct and portfolio investment.

But the fund cautioned Estonia that this large flow of capital coming in could push the banking system to "overextend itself and face liquidity problems" if the credit risks of the loans it is now making turn out worse than expected, or if the capital inflows slow down or stop.

As South Korean officials can attest, a sudden halt of inflowing capital -- followed by quick withdrawals -- can leave an unprepared or weak banking system in a very precarious position.

The fund noted, however, that the Central Bank of Estonia has already moved to start dealing with this problem, recently raising the capital adequacy ratio for Estonian banks and significantly increasing the level of required reserves for banks.

In addition, during the next three months, the IMF noted, these measures will be reinforced as banks will be required to set aside a general risk reserve, raise their minimum capital requirements to the equivalent of five million ECU (European Union currency), and observe international bank standards.

The IMF's executive directors said the currency board arrangement of the central bank "remains an effective tool in Estonia," but reiterated there should be a cooling of the rapid expansion of domestic bank credit because the pace of such growth could outstrip commercial banks' ability to assess risks properly.

They said Estonian authorities must "implement vigorously" the enforcement of bank standards, to extend those rules to non-bank financial institutions and to generally strengthen bank supervision.

The directors warned Estonia to "monitor very closely" financial developments in the coming weeks and "stand ready to take additional action if necessary."