Estonia 1.2. Economic Performance and Market Reforms. General developments

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1 Estonia 1.2. Economic Performance and Market Reforms General developments Estonia is one of the most successful emerging market economies in Central and Eastern Europe. The GDP has grown by an average of 5% since middle of 1990s. During 2001, the GDP growth was 5,0% and 5,6% growth is estimated for The GDP growth slowed down only slightly in the last quarter of Though Estonian open economy is very dependent on demand of foreign markets, first of all from exports to Scandinavian markets, the modest growth rates in those countries did not influence too much the GDP growth. Domestic private consumption and investments stimulated the growth with expense of current account deficit. The growth outlook is clouded by uncertainty about the prospects of world markets in The rather weak export demand in the EU is the source of concerns about the sustainability of current growth pattern. Increased domestic demand accompanied by a growing credit burden generates risks for the economy, especially is a small open economy, where the important source for growth has been exports. The investments started to grow very rapidly since For the year, 16.0 % growth has been achieved and by first estimation, capital formation created 30.3% of the GDP in The industries show signs of additional expansion of production capacities, which was accompanied by fast growth of investments. The Estonian monetary system is based on currency board arrangement since The Estonian national currency kroon has been first pegged to German mark and since 1999, to the Euro. All kroons in circulation are backed 100% by foreign currency and gold reserves. The currency board system with fixed exchange rate created necessary financial discipline and made possible to achieve relatively low inflation rates since second half of 1990s. Also the interest rate levels have been pushed down. In 2002, the consumer price index was 3.6% and the average interest rate of long-term loans 7.8%. In the government sector, the budget revenues for 2002 were larger than expenditures and surplus at the level of 1,2% GDP has been created. Higher revenues in public sector had been supported by better tax discipline and higher than forecasted growth of the GDP. However, several local governments had problems with balance of revenues and expenditures. Partly that has been caused by unequal distribution of growth between regions. Industries The structure of the Estonian GDP has become rather close to that of the GDP of developed countries. The shares of trade, transportation and the service sector have increased rapidly. The activities which had very limited role or did not occurred at all like commercial banking, business services and real estate grow rapidly in new market economies. The share of services in the GDP increased from 48% in 1993 to 62% in

2 Traditional manufacturing industries like food processing, textile and machinery went through major changes of ownership, technology and markets which has been accompanied by decline of output. So did agricultural sector, which part in the GDP declined to 3.4% in 2001 At the same time new enterprises in electrical machinery and apparatus, manufacture of radio, television and communication equipment and apparatus have been created and increase of output based on subcontracting for Scandinavian companies occurred in those branches. Wood processing has been another rapidly increasing branch based on domestic forest resources. The gross output of industry increased by 4.6% during Promoting Estonia as a good place for transit trade has been important target for economic policy for the recent years. Transit trade created around 7% of the country s GDP. Oil and oil products made up around two thirds of freight that passed Estonia s ports, followed by fertilizers, container cargo, metals and timber. Total amount of cargo handled by Estonian ports was close to 40 million tons in Tourism has been one rapidly increasing area of service sector. In 2002 almost 3.5 million foreign tourists served by Estonian tourism firms visited Estonia. About 80% of foreign visitors came from Finland. As a result of a very intense traffic of vessels between Tallinn and Helsinki, especially the number of same-day visitors from Finland increased steeply. A specific feature of the Estonian energy sector is oil shale, which accounted for 59.4% of primary energy supply in As much as 90% of electricity was generated from oil shale. Oil shale is characterised as a fuel with low heating value. The production of electricity is concentrated in Narva, Northeast Estonia. There are two thermal power stations, the Baltic (with potential output 1435 MW) and the Estonian (1610 MW) power station. The renovation of Estonian power station on the base of new technology of burning oil shale started in summer Estonia as the other Central and Eastern European countries, privatised its companies in 1990s. In 2002, the private sector created 80% of economy. After concluding largescale privatisation in middle of 1990s, the privatisation of telecommunications, energy sector and infrastructure continued until The Estonian Railway Company was privatised in Telecommunication market was, after sale of big part of shares to foreign companies and public before 1999, liberalised since beginning of In 2002, the sate still kept approximately 30% of shares. Process of privatisation Eesti Energia, the state-owned energy company, started in 1995, but failed in The Government, in the very end of that procedure, decided to restructure the company and finance necessary investment with credits from international financial markets. Financial sector The creation of two tier banking system with central banks responsible for regulation of monetary and banking system in general and commercial banks providing 2

3 companies and households with financial services was one the major economic reforms in all Eastern and Central Europe including Estonia. At the beginning of the reform process, the Estonian government concentrated on implementing effective monetary and exchange rate policies and improving the regulatory role of the central banks. After recurrent financial crises, the central bank has since carried out a major restructuring of the banks, based on consolidation, privatisation and opening the sector to foreign participation. As a result, the country today has banking sector that is characterised by improved supervision and governance, a high degree of concentration, and large degree of foreign ownership. The participation of foreign banks has been critically important. They have not only contributed much needed capital resources, but introduced new banking technologies and know how and good banking practices. They have improved the competitive environment and helped to restructure struggling domestic banks. There are concerns, however, about the concentration of economic power in the hands of foreign investors. In recent years, Estonia has developed a modern regulatory regime for the banking sector. For example, there is enacted law ensuring the independence of the central bank, provided institutions and tools for better supervision of credit institutions, established legal reserve requirements, provided insurance for deposits, and improved their payment and settlement systems. In 2002, the 85% of share capital of banking sector was owned by foreign banks, Swedish Swedbank (controlling the largest Hansabank, the largest bank in the Baltic market) and Skandinavska Enskilda Banken (owner of second largest Estonian bank, the Union Bank) being the leading foreign investors. The Estonian banking system is nowadays modern and efficient, with the strongest and best regulated banks in the region. These banks provide both domestic and international services at very competitive rate. Estonia has an advanced Internet banking system: 43% of inhabitants made their everyday transactions via Internet banking in A major positive influence on the banking sectors was the high priority assigned to negotiating memberships in different international organisations, particularly the EU, and the WTO where Estonia is a member November International commitments have encouraged improved domestic regulation and market opening. They also created a binding framework for a large number of domestic political debates about various economic and financial issues. Foreign direct investments Foreign investment has been one of the solutions to the structural changes necessary for development. A significant part of direct investments came from Sweden (41%) and Finland (30%). The most attractive sectors for foreign direct investors were in Estonia finance, transport, storage and communication, manufacturing, wholesale and retail trade. 3

4 The total amount of foreign direct investments (FDI) into Estonia, which according to the Bank of Estonia was 60 billion kroons in end of 2002, places Estonia in a satisfactory position among other Eastern European countries. However, in 2002 the amount of FDI decreased to 5.2 billion kroons from 9.4 billion in The decrease was caused by end of privatisation and temporary low growth in Scandinavian countries, which caused re-evaluation of investment decisions. The big proportion of reinvested corporate profits, on the other hand, evidenced that business environment is still reliable and foreign companies continue their activities. Investment climate has been supportive for foreign investors in Estonia. The legal framework is harmonized with the EU. There is an unrestricted opportunity for repatriation of profits and very favourable tax system. Estonia has a flat 26% income tax. Since 2000, all reinvested corporate profits are exempted from corporate income tax in order to encourage enterprises to reinvest their profits. Foreign trade Foreign trade has been one of the deciding factors of the country s development. The total turnover of exports and imports exceeded the volume of GDP by 1.5 times. The share of exports was at the level of 60-62% of the GDP during recent years. Estonia s foreign trade policy has been somewhat unique: customs tariffs practically did not exist in 1990s and restrictions to enterprises in developing foreign economic relations were minimum. Only from 1 January, 2000, the limited number of tariffs have been introduce on agricultural products against non-eu countries and those which do not have free trade agreement with Estonia. Estonian exports and imports have been rapidly increasing since The weak demand for Estonian exports diminished the total amount of exports by 2% in Imports at the same time increased by 6% and foreign trade deficit respectively grow. Machinery and equipment, still the largest section of exports, decreased almost 30% due to crises in IT sector. Exports of other Estonian key sectors wood and wood products were up 11%, and textile and textile products by 2%. Most important import items were machinery and equipment with 29.7% and transport vehicles with 10.8%. Imports for manufacturing in Estonia and for later re-export created approximately one third of exports. The structure of Estonian imports has been determined by the necessity to purchase fuel and other raw materials (e.g. cotton as an important input for Estonia s rather large textile industry). Machinery, mechanical appliances and electrical equipment have also been important imports. The geographical pattern of Estonian foreign trade changed very substantially in 1990s. Finland played a very important role, encouraged by its knowledge of these markets and its linguistic similarity. Finland also acted as mediator for Estonian entrepreneurs. Another reason why Finland s share is high in the Estonian foreign trade is the large number of foreign direct investments from Finland in Estonia and those enterprises created on the basis of those investments use to trade with Finland. The share of Finland was 24,2% of exports and 17,2 imports, followed by Sweden with 15,3% of exports and 9,5 imports and Germany with 9,9% exports and 11,2% imports in

5 Since 1995, when Estonian main trade partners Finland and Sweden joined the EU, former started to be main region of Estonian foreign trade. In 2002, the EU gave 68% of Estonian exports and 58% of imports. In commodity structure of Estonian exports is possible to see that traditional export articles like textile and food products declined in relative and absolute terms and machinery and equipment had the largest share with 24.8% in Estonian exports in Wood and articles of wood created 15.1% of exports in Other titles in this section were chip and fibreboards, plywood and construction details. Also furniture has been important article of exports. The textiles and textile articles created 12.1% of exports in Subcontracting accounted a big share of the exports of clothes but amount of final products has been increasing in recent years. The main markets were Finland and Sweden, which also were the major customers of subcontracting. Russia s share of Estonian foreign trade declined dramatically in 1999 after financial crises and deep devaluation of ruble, but recovered afterward and created 3.3% of Estonian exports and 7.4% of imports in For certain items, Estonian producers and traders are interested in having economic linkages with Russia. Transport vehicles created quite important share of Estonian export to Russia (mainly as re-export but safety belts for Russian car industry has been one important item). Among Estonian imports the dominant item was mineral products (mainly oil), making up one third of Estonian imports from Russia. As Estonia does not have the MFN agreement with Russia, Estonian exports suffered for higher customs tariffs. Trade with the other Baltic countries, Latvia and Lithuania, has been rather modest. In 2002, Latvia s share of Estonian exports was 7.4%. Lithuania s share was 3.5% of exports. Estonia, Latvia and Lithuania signed the Baltic Free Trade Agreement in 1992 (enforced since April 1994). Additionally since 1997 have been valid a free trade agreement on agricultural products. Labour market The situation in labour market has steadily improved during last couple of years and unemployment rate declined to 10.3% in There are big regional differences, The East Virumaa county with dominantly Russian population having highest unemployment rate with 18.9%. That is more than two times higher in comparison with counties having lowest unemployment rates. The main problem of labour market is low quality of labour. During restructuring and application new technologies, new industries have not managed to find enough employment. The existing training system has not offered the necessary opportunities to retrain people. The vocational training system is in deep crises and seems to become a main obstacle for future employment. The new law to create an unemployment insurance system passed in 2001 and has been in force since January In order to be eligible for payments from the Unemployment Insurance Fund, a person must contribute to the fund 12 months. Some analyst expected increase of unemployment in the beginning of 2003 because several big companies expected for dismissals until unemployment insurance started 5

6 to operate. However, during first quarter of 2003, no dramatic changes occurred in this field. Future developments Along with nine other candidate countries, Estonia finished accession negotiations with the EU in December Estonia is expected to be a member of the EU in May The invitation to join NATO came in November 2002, only some weeks later than from the EU. The importance of the EU is especially clear, because Estonia is one of the poorer countries among the new candidate countries. During the accession negotiations, the EU promised Estonia regional support for the years up to 3.7 billion kroons each year. In addition to that, 1-2 billion kroons goes for agriculture. In comparison it is worth to say that Estonian GDP was 106 billion kroons in There are many other issues related to membership of the EU. Harmonisation with the EU legislation improves market access by dismantling technical barriers to trade. However, there is also danger that too early harmonisation with EU regulations can constrain Estonian competitiveness and comparative advantage and thus slow down the growth. If Estonia joins the EU; the trade policy becomes an EU competence. Estonia has to implement the external trade policy of the EU. As Estonia has currently practically zero-protection, it means that we can have no gains in falling import prices from further trade liberalisation. EU integration leads to increase in protection level toward non-eu suppliers and, hence, to trade diversion. However, the effect of implementation of EU tariffs will be fairly small because majority of trade will be with EU members and the EU has not high protection level in raw materials, which are currently the major import articles from EU non-members. 6

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