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Standard & Poor’s Ratings Services has affirmed its ‘A-/A-2’ sovereign credit ratings on the Republic of Estonia, as rapid economic growth has led to positive fiscal performance, but increased the country’s dependency on foreign borrowing due to the widening current account deficit and a slowdown in net foreign direct investment (FDI) inflows. The outlook is stable.

The ratings on

  • Estonia are supported by its high levels of economic growth and investment following the implementation of market-oriented policies since the onset of transition, a track record of fiscal prudence, and predictable economic policy despite a high turnover of governments.


Among EU accession countries, Estonia has been at the forefront of reforming its market rules and institutions, making it one of the most unrestricted economies in Europe. Output is forecast to continue to expand by about 5% per year, with investment accounting for 28% of GDP over the medium term. High growth has led to general government balances oscillating between modest deficits and surpluses. As a result, Estonia’s general government debt burden is projected at about 5.9% of GDP at year-end 2003, which will rise only gradually to 8.5% of GDP by 2005. Fiscal deficits will remain contained at or below 2% of GDP in the coming years notwithstanding the build-up of fiscal pressures related to pension reform and the country’s accessions to the EU and Nato, both of which are expected to occur in 2004.

“Despite numerous changes in government, the fiscal policy stance has remained prudent since independence,” says Standard & Poor’s credit analyst Moritz Kraemer. “Similarly, the authorities remain firmly committed to monetary stability. The euro-linked currency board has endured a number of serious domestic and external shocks, strengthening its credibility.”

The ratings on Estonia are constrained by significant external imbalances and structural challenges still ahead. Although Estonia’s level of development justifies drawing on foreign savings to build up productive capacity, the current account deficit almost doubled in 2002, to reach an estimated 11.5% of GDP, and is forecast to decline only gradually. FDI coverage dropped from more than 100% of the current account deficit during 1999-2001 to under 25% in 2002, making Estonia a net external debtor. Under Estonia’s currency board, monetary conditions are determined by external financial conditions and are expected to remain accommodative. Fiscal policy would therefore have to be tightened in order to reduce the external imbalances. As the fiscal stance is loosening somewhat, Standard & Poor’s expects that the large current account deficit will decline only very gradually and require external borrowing. As a result, net external debt will rise to 15% of current account receipts in 2005, from nil in 2001.

“In the long term, Estonia faces the challenge of engineering real institutional and economic convergence with higher-rated sovereigns,” says Kraemer. “Although the country has made substantial progress toward adopting EU rules and regulations, it will need to ensure that this new body of law filters down to the real sector of the economy. In addition, Estonia’s per capita income, at US$6,000 in 2003, is rising fast, but remains well below that of other A-rated sovereigns.”

The stable outlook reflects the balance of risks to economic development and government finances. With EU accession in mid-2004 now almost a certainty, Estonia will enter the European Exchange Rate Mechanism (ERM II) by 2004 and may become a member of EMU as early as 2006. This will protect Estonia from one of its key weaknesses, namely its weak external liquidity position. The large and persistent current account deficits projected through 2006, however, could pose potential risks in the transition to EMU. Under Estonia’s currency board mechanism, a further drop in FDI and pressure on the capital account of the balance of payments could cause very tight monetary conditions, thwarting economic growth and weakening public finances. Conversely, a smooth transition toward EMU and a continuation of the speedy real economic convergence process could lead to further rating upgrades for Estonia.