Vahur Kraft. European Integration - Challenges and Expectations as Seen by an Accession Country
European Integration - Challenges and Expectations as Seen by an Accession Country
Governor of the Bank of Estonia
In the 1980s when Estonia was still part of the Soviet Union it was often said that Estonians were the idiots who 'compiled with Russian regulations with a German correctness'. The reference to something German in this context was, certainly, not accidental, for the cultural myth about 'Germanized' Estonians, Latvians and Lithuanians was still surprisingly strong - even if it was rather evident that the Estonia of those times was a world away from Germany. The myth, in fact, does have some grounds in reality, insofar as it could be seen as a reflection of the one-time strong dominance of German culture in the Baltic region. That influence, by the way, can be traced in the very word used for 'regulation' in the Estonian language - eeskiri. Which is a direct word-by-word translation form the German Vorschrift. Again, the German word for this type of word-borrowing should be Lehnübersetzung, which is another word the Estonians have directly translated from the German language.
Besides the close cultural ties of the old times and the close economic ties of the modern times Estonia will soon be come a part of what is generally perceived to be the very core of Europe - the European Union. What are the challenges an accession country has to meet on its way to EU? What do we expect from the integrated Europe?
We hope that, for Estonia, the most serious challenges are past by now. The necessity of relatively deep initial restructuring and serious social adjustment ten years ago has, paradoxically, helped Estonia to focus its reform efforts so that they have been all the more successful. Being a newly independent country, Estonia had to rebuild its most basic elements of credibility from nothing - and that is where monetary strategy has been probably one of the key factors (albeit not the only one), providing a stable framework for the functioning of the market economy.
Since 1992 Estonia has operated a currency board based monetary system. The anchor currency has been the German mark and, later on, the euro. The exchange rate fixed in 1992 has never been changed. Currency board means a full reserve backing of the monetary base, it means automatic intervention on the spot forex market as the sole active policy instrument, and no central bank interest rates - the key monetary policy rate for Estonia is the ECB main refinancing rate. Estonian financial sector refinances its operations in European money and repo markets and consequently, the banks obtain kroon liquidity by trading euros to kroon via central bank's automatic forex window. Through the peg to the euro Estonian financial sector and real sector operate, by and large, under the same monetary conditions, that would apply if Estonia were a member of the EMU today. For a currency board, the ERM2 entry would mean a relatively small change in that sense.
Due to the automatic stabilizers built into a currency board arrangement the adjustment processes in Estonia have been, perhaps, more rapid than under a more conventional monetary environment. But that may be all to the good from the point of view of the country's preparations for the EU accession, as the structure of the economy has proved to be flexible enough to respond to changing external demand and domestic productivity shocks.
By now, Estonian economy is strongly integrated into the European economic area. The share of current and future EU member states in Estonian exports is about 81%. Recent Estonian economic developments have been quite favorable, especially against the background of global slowdown. Investor and consumer sentiments have remained high, partially supported by positive future outlook and partially encouraged by lower than expected interest rates. In 2002 Estonia's real GDP growth was 5,6%, CPI growth - 3,6%, average long term kroon lending rate (end 2002) was - 6,4%. According to the latest estimates the current account deficit exceeded 11%. The government budget was in surplus by 1,2%. Estonia is no longer the catching-up candidate country it was three-four years ago. However, we still cannot say that the restructuring of our economy has been completed.
What are the main challenges ahead? For Estonia, like for all new member states the only possible way to join the euro system is to do it in full compliance with the letter and spirit of the EU Treaty.
ERM II provides, in principle, a much needed buffer zone before the EMU entry. However, there are obvious risks involved. It is of paramount importance that the decision on ERM II entry be taken only when macroeconomic fundamentals provide for a realistic deadline for the entry into the euro system in, say, two or three years' time.
Joining the euro system means the fulfillment of the Maastricht criteria - and the ability to adhere to the requirements of the Stability and Growth Pact over a longer term. Here, again, it could be said that our choice of a monetary regime has brought us some advantages over most of the other accession countries. Fiscal balance is a very important prerequisite for a smoothly operating and effective currency board arrangement, and that has had a strong impact on Estonian fiscal policies over the last decade. At this point, we expect no great difficulties in meeting the sovereign debt and budget deficit criteria - Estonia's general budget has been roughly balanced or even in surplus over the last couple of years. In that sense - Estonia would be ready to join the euro area at an early date - maybe even as early as 2006.
What can cause some specific problems is the inflation criteria, however. Meeting the inflation criteria might not be as difficult as sometimes expected. But within the context of a rapid accession it becomes a serious issue, not least, because inflation is a crucial economic policy issue under a fixed rate of exchange. A gradual increase of price level is an inevitable result of real convergence under a fixed rate of exchange. According to our PEP the annual consumer price indices are expected to fluctuate in the range of 3,5-4,2 per cent during next 3-4 years. We believe that a small difference between Estonia's and Euro Area inflation would be natural takind account the ongoing convergence. We presently assume that every 1 percentage point GDP growth differential between EU and Estonia would lead to an average 0.7 pp differential in CP inflation and that nominal convergence will coincide with real convergence over medium term.
Does the inflation development in Estonia, so far, support the assumption that, for the most part, a differential vis-à-vis the Euro Area can be explained by real convergence? There are several indications that it might indeed be so - that a substantial part of inflation is caused by the Balassa-Samuelsson effect.
Estonian economy is integrated into European product and capital markets, providing the necessary preconditions for Balassa-Samuelsson effect to materialise. The price level in the open sector is fairly stable and initial price distortions have been largely eliminated.
The ratio of open sector and sheltered sector wages has remained constant over time, thus supporting the assumption that wages in sectors with lower productivity have kept pace with those of higher productivity industries.
The productivity growth in the open sector of the economy has constantly outpaced productivity increases in the sheltered sector. It should be noted that over the last 6 years the cumulative productivity growth in Estonia, relative to its main trading partners, has amounted to 25 per cent. The corresponding CPI-based real exchange rate appreciation amounts to 22 per cent . Based on all that it could be said that at least at the present moment Estonian inflation performance is in line with medium term convergence scenario.
Inflation-related issues are important, but they are not the only challenges ahead for countries like Estonia. One only needs to think about the possible consequences of an increase in the more volatile capital flows to the accession countries to understand that. In the forthcoming years we must keep an especially watchful eye on the external equilibrium of our economy.
Estonian economy is an extremely open one - export and import reach 170-180% of GDP. That means a relatively high exposure to external shocks. It is obvious that no country, especially a country like Estonia, should assume an excessive current account deficit spanning several years when planning its economic policies. Even if the deficit is financed by foreign direct investment - as it is in case of Estonia -, adaptation of the economy is inevitable. The economic policy should be to focused on the prevention of an internal demand driven boom immediately prior to and after the EU accession which would be inevitably followed by a significantly slower growth phase.
Estonia's trade and capital flows have been fully liberalized already for nearly 10 years and FDI has always been the main source of capital inflow, exceeding even 10% of GDP for some years. By today total FDI stock amounts to almost 60% of GDP and is quite evenly balanced between the main sectors - manufacturing, transportation and finance all account for approximately 1/5 of the stock. This indicates that foreign investors have already for some years counted in Estonia's future membership in the EU. Furthermore, our free-trade agreement with EU offers the possibility to use Estonia as productions location in supplying the single market already today, except for agricultural products. In this light it is quite difficult to envisage that after the accession FDI inflows to Estonia will increase drastically.
Most of what was mentioned above also hold true for the perspective of short-term capital flows. Rating agencies and investors have already priced in the future EU membership. Credit ratings for some accession countries, including Estonia, were recently upgraded to a level comparable with some Euro area economies and our risk premiums have decreased constantly. Thus, the temptation for higher borrowing is strong already today. It is not accession per-se that would force us to take the issue very seriously.
It must certainly also be noted that the current account is expected to remain in considerable deficit over the next few years. We believe that this is a reflection of real catching up - a substantial share of capital inflows is directly related to differences in marginal productivity. Over the medium term the saving-investment gap is expected to stabilize, however, at a 6-7% level of the GDP.
The biggest challenge for the public sector would be to avoid a lax macroeconomic policy mix that would over-stimulate domestic demand and result in significant real appreciation. In order to balance the possible pressure on domestic demand, fiscal policy should have enough flexibility and an adequate institutional framework must be in place to ensure efficient use of official transfers.
What about competitiveness? Recent experience shows that neither the fixed nor flexible exchange rate arrangements can avoid the real appreciation caused by a relatively high productivity growth in the open sector and capital inflow in the EU accession countries. The appreciation of the real exchange rate is the reflection of real convergence and, thus, should not indicate the loss in competitiveness per se.
The cumulative productivity growth in Estonia relative to the weighted average productivity growth of its main trading partners has clearly outpaced the real exchange rate appreciation.
Inflation and competitiveness performance over the last decade has been encouraging. Price level developments over the last years have depended mainly on the speed of real convergence. Other indicators of nominal convergence have behaved expectedly. For example, the interest rate margin over the Euro area average is around 1 percentage point in the money market and 2-3% in the retail market.
Given the peculiarities of a currency board and a transition economy, it is extremely important for a country like Estonia to have a strong financial sector. It is fair to say that Estonian banking system is presently strong, well capitalized and liquid. The banks' forced reliance on their own capital and liquidity have had a direct impact on the market structure as they were forced to look for strong partners. Strategic foreign ownership - mostly by Scandinavian financial groups - has provided Estonian banks with both strong capitalization and transfer of international best practices. At the present time a Estonian banking sector is responsible for a significant share of the profits of their owners.
Profitablility means effectiveness at least comparable to the financial sectors of our neighbouring EU member countries and a somewhat greater flexibility of production factors, especially the flexibility of labour markets. Profitability also means a relatively rapid adoption of new technologies. For example, the number of card payments per capita in Estonia should be roughly equal to the respective German figures while the share of internet banking customers is somewhat higher (and the list of internet-based bank services somewhat more exhaustive) in Estonia.
Apart from high Nordic ownership and an increasing number of Estonian kroon bond issues in the integrated market, the owner of Helsinki Stock Exchange HEX Group which recently announced a merger with the Stockholm stock exchange has acquired a majority holding in the Tallinn Stock Exchange and both stock exchanges operate in a common trading environment.
Speaking about future developments in Estonia in the light of the challenges shortly discussed above it is good to bear in mind that policy efforts are necessary also after becoming part of the EU and the EMU. For example, fiscal policy will remain an important stabilization tool. Various issues concerning the flexibility and efficiency of labor, product and capital markets can be seen as important challenges both before and after the accession.
I am convinced that EU membership will be beneficial to Estonia. But I am also very sure that Estonia has something to offer to the EU in its turn - some experience and ideas for handling the issues pertaining to the flexibility and mobility of production factors, for example.
The European Union is facing several complicated but well-known economic policy problems from the recent past. It is important that Estonia as a future EU member state be able and willing to participate in the discussions and offer its contribution towards the common goal. We must perceive Estonia in Europe and Europe in Estonia.
 The cumulative increase in the CPI based REER index from Q1 1997 - Q2 2002 was 18%. At the same time, the trade-weighted cumulative productivity growth differential vis-à-vis 12 main trading partners increased by 27%. Even with the current slowdown in Estonia's subcontracting industry direct exports have maintained their positive and quite stable growth rate (~10% y-o-y).
|Vahur Kraft. European Integration - Challenges and Expectations as Seen by an Accession Country|