Estonia has successfully mastered the transition from a planned to a market economy. It has established a rather liberal economic regime, flexible labour markets and a business-friendly environment. At the same time, it has achieved a high degree of macroeconomic stability, supported by a sound fiscal policy. Estonia joined ERM II in June 2004, maintaining its currency board arrangement as a unilateral commitment. Average growth between 2000 and 2004 was 6.5% per year, while estimated potential growth is even higher. The main macroeconomic imbalance is a high external deficit. Although this largely reflects strong investment needs in the catching-up process, public savings will continue to be required as an important counterweight to low and declining household savings.

This article looks at the main underlying factors driving Estonia’s external imbalance and provides some reflections on sustainability issues, as well as on the role of fiscal policy. It concludes that Estonia’s external deficit does not reflect fundamental imbalances that would require drastic policy reversals, but that it does nevertheless increase the economy’s potential vulnerability to unfavourable external developments.

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