Analytics, Covid-19, Estonia, EU – Baltic States, Financial Services, Good for Business, Investments

The short-term rating was affirmed at A-1+.

"Like all European economies, Estonia is severely affected by the pandemic. However, a strong policy response has contained the spread of the virus and the impact on domestic demand has been lower than initially forecast. We currently expect that Estonia can achieve 2019 real GDP levels in the second half of 2022, once there's no significant resurgence of domestic COVID-19 cases or a protracted downturn of the main trading partners," S&P said.

The agency estimates that Estonia's economy will contract by 6.8% this year, with most of the downturn in the second quarter. The decisive initial policy response has contained the domestic spread of the virus and authorities have rolled back most restrictions.

S&P said it would expect Estonia to revert to annual growth closer to 2% in real terms after 2022, provided that the downturn at Estonia's main trading partners is not protracted.

Domestic demand in Estonia has started to recover following the lifting of lockdown measures, and external demand has not dropped as sharply as expected. Estonia's most important trading partners -- the other Baltic countries, Finland, Sweden, and Germany -- which account for almost 50 % of exports, have not been as severely affected as some other EU economies.

Despite Estonia's generally benign post-pandemic growth prospects, there are several risks to a swift economic recovery. For example, domestic demand could falter if COVID-19 cases increase and restrictions are reintroduced. On the other hand, as a small, open economy, Estonia would not be resilient to further economic downturn in its key trading partners.

"Another element that will support the economic recovery will be the new EU Multiannual Financing Framework (MFF), estimated at 1.8 trillion euros, including the Next Generation EU funds. Although many details on fund allocation to individual member states remain unclear and could change, we believe the current proposal suggests total funds allocated to Estonia through the various EU financial programs under the new MFF will increase," the agency said. It added that given Estonia's track record of swift and effective absorption, its believes the country will use the funds quickly once they become available.

Estonian authorities' strong fiscal policy response to support the economy and labor market during the pandemic will likely push public deficits to 6.3% and 3.3% of GDP this year and next. However, fiscal policy space remains ample, since the country still reports the lowest debt of all eurozone members. Although rising, S&P believes public debt, net of liquid government assets, will stay below 10% of GDP at least over the next three years.

"Once the economy recovers, we believe the labor market will become extremely tight again. At the same time, Estonia's demographic shifts have historically been less adverse than in other Baltic states. Unlike regional peers, Estonia's population has increased over the past five years, supported by net immigration, particularly from Finland, Latvia, Russia, and Ukraine. In addition, the implementation of labor reforms, especially the work ability reform of 2016, has increased the participation rate, and we consider the labor market to be very flexible by European standards," it said.

S&P said it could raise the ratings if, once the pandemic subsides, Estonia again shows strong growth dynamics that boost its income levels. It believes this would most likely reflect productivity gains in high-value-added services sectors over the next few years, resulting in sustained external surpluses. A strong economic recovery would also enable a return to Estonia's previously very strong fiscal balances and reduce public debt.

It could lower the ratings if the direct and indirect impact of the pandemic on Estonia were more significant than it currently expects.