V.Kraft. Challenges Facing Estonian Economy in the European Union

CHALLENGES FACING THE ESTONIAN ECONOMY IN THE EUROPEAN UNION

Vahur Kraft
Bank of Estonia, Governor

Roundtable "Does the social market economy have a future?" organised by the Konrad Adenauer Foundation
August 19, 2002

A. INTRODUCTION, REVIEW OF THE EARLY 1990s AND COMPARISON WITH THE PRESENT DAY

First of all, allow me to thank the Konrad Adenauer Foundation for the organisation of this interesting roundtable and for the honourable invitation to speak about the challenges of the Estonian economy in the European Union. Today's event shows yet again how serious the respected organisers' interest towards the EU applicant countries is.

I highly appreciate your support for our reforms and convergence in our society and economy. From the outside it may seem that the transformation and convergence processes in Estonia have been easy and smooth, but against this background numerous hidden problems still exist. One should not forget that for two generations half of Europe was deprived of civil liberties, private ownership, and a market economy. This is a truth and it has to be reckoned with.

It is also clear that the reflections of the "shadows of the past" can still be observed today, though they are of a different kind. If people want the state to ensure their well-being but are reluctant to take any responsibility for their own future themselves, it is an effect of the shadows of the past. If people are reluctant to pay taxes but demand social security and good roads, it is the shadow of the past. In brief, if people do not understand why elections are held and what the state's role is, it is the shadow of the past.

But, of course, in the past ten years a lot has been achieved. We have built up democratic institutions. A market economy is in place and functioning. Private ownership has a solid foundation. Banks provide credit to people for new housing developments. However, our current success should not be taken for granted. In addition, we should also bear in mind that much still needs to be done. The public has to understand the role and possibilities of the state and government in a market economy. Everybody should feel some sense of responsibility for their own welfare as well as their family's and the state's well-being. Our new generation should be able to cope with the complicated processes of modern society much better than we have.

In our efforts to achieve this goal it is impossible to underestimate the support provided by our partners. Estonian society and its politicians need partners to exchange experience with and from whom to still learn the fundamentals of a functioning civil society. With this in mind, I would like to thank the Konrad Adenauer Foundation for the work it has done and is still doing in Estonia and elsewhere for the promotion of political co-operation, for the preservation and support of free democracies throughout the world, as well as the development and consolidation of the social market economy and its respective values.

Please allow me to also recognize the contributions of Prime Minister Mart Laar, who was the leader of the Estonian government during several critical periods in the past. Mart Laar was the head of the Estonian government during one of our most difficult periods, from the autumn of 1992 to November 1994. This was at turbulent period of initial reforms not only in the economy but for society as a whole, which immediately followed the monetary reform and adoption of the constitution. However, with your kind consent, I shall hereby focus my attention solely on economic issues.

Those were the times when Estonia's foreign reserves, valued in the current denomination, could have been expressed in the hundreds of millions of euros, the average monthly wage was slightly above one thousand kroons and, by the end of 1992, three big banks had collapsed. Those were the years just after the monetary reform when the question "How long is this kroon going to last?" was often asked in Estonia, but even more frequently abroad.

The central bank has always stressed the essential backing provided to the stability of the kroon's exchange rate and the financial system by the economic reforms at large and a stable, predictable budget in particular. We have repeatedly emphasized that the foundation of our relative economic success was laid in 1992 and 1993. Our banks would not be as strong today without solid customers - both private enterprises and individuals. The quick and resolute privatisation of former state-owned companies in the beginning of 1990s was a decisive factor in the establishment of a strong and sound customer base. Due to that, Estonian banks have been particularly able to extend credit to the strong private sector. Thus, we managed to avoid the situation that many former socialist economies were forced to experience - the floating of problem loans directly or indirectly to state-controlled and often corrupt industry.

In the course of the reorganisation of the financial sector in the early 1990s we did not hesitate to liquidate badly-managed, insolvent banks in the first half of the decade. Neither did the government hesitate when it was necessary to liquidate badly-managed, insolvent enterprises that were manufacturing for stock. The privatisation of state-owned companies to core investors for hard currency, and, when necessary, the liquidation of state enterprises that were operating in the red, created a good basis for the emergence of a strong and free competition-driven business sector. Without it the real wages in Estonia would not have increased by almost one-third in the second half of the 1990s. Without it we would not be approaching the finish line in our EU accession process. Steps taken ten years ago for the demolition of the old, impotent and futureless system and for the building up of a new, viable and future-oriented economy are now bearing fruit.

The basis of the economic reforms undertaken by the government in the early 1990s was a strong fiscal policy. Let's be honest. At that time, none of us knew exactly what a national budget really was or how the amount of state-collected taxes and public expenditure would, in practice, affect the economy. One thing was clear - public expenditure should not exceed public income or the value of the Estonian kroon would immediately be at risk. The strict balance-oriented strategy of 1992-1993 helped to create the social foundation that would even today be suitable for developing a fiscal policy capable of even better supporting a balanced economy.

I have touched upon the key economic policy issues of the past decade because the same issues that were topical then are on today's and tomorrow's agendas too. How can we achieve better economic efficiency and improve competitiveness? How can we avoid the negative impact of local lobby-groups on economic policy and ensure a truly effective and free market? How can we develop a truly balanced and forward-looking fiscal policy? These issues are in focus not only in Estonia but also in the European Union as a whole. Naturally, today's problems - like society itself - have a completely different look now than they did 10 years ago. It is not only Estonia that has changed, it is the entire world. However, the key questions and their optimum solutions are, in essence, the same.

I would like to offer just a few examples to the illustrate the above-mentioned points. In the beginning of the 1990s we created conditions for truly free competition in the financial sector and the entire economy in Estonia. Estonia abandoned all possible barriers to the import and export of goods and services, and created equal opportunities for all investors and privatised state-owned banks. These steps laid the foundation of our current success. Now, 10 years later, Estonia, like the European Union, is widely discussing how to create a truly free market of infrastructure services which until now have been either directly or indirectly protected by the state. Furthermore,the principal solutions to this problem shall not differ from the decisions made in the first half of the 1990s.

It is true that, for example, the opening up of the electricity market to free competition is definitely more time-consuming than the privatisation of many industrial enterprises. However, the restructuring of the electricity sector does not differ in principle from the reform of the banking sector. In both cases the state must ensure the availability of the critical infrastructure in Estonia and communication with the external markets. In one case, it means payment systems; in the other case, interconnections with the European and Scandinavian electrical grids. In both cases the government has to ensure supervision over the market actors' behaviour and establish clear rules. In both cases the government must have action plans or guidelines for crisis management. When these guidelines and relevant national policies are in place, there will no longer be impediments to the complete opening of the market. The task of the government is not to delay the opening of the market but rather to hasten it. I am positive that society, as in the banking sector, will benefit from this. It will result in more efficient production, lower prices, a higher level of service and curb the power of monopolistic producers.

Nowadays, as in the early 1990s, we again face the question of what is the right fiscal policy. Of course, today this problem is raised in a slightly different way, though, in essence, it is the same question - which fiscal policy shall ensure the stable development of the Estonian economy within the fixed exchange rate regime and as part of the euro area. I shall return to this question towards the end of my presentation.

Thus, the key economic policy issues we are facing in the beginning of the 21st century resemble in many aspects the problems we tried to resolve in the beginning of 1990s. We have achieved progress in finding solutions to some of the problems, although others have remained unresolved. One thing is clear - the undue postponement of tough issues is not good for anybody. If we want to be treated as equal partners in the European Union, if we want to sustain our rapid growth rate and growing income level, then we must tackle these problems with the same resolution and energy that we had 10 years ago.

B. CHALLENGES FACING THE ESTONIAN ECONOMY ON ITS WAY TO THE EUROPEAN UNION - INTERNAL POLICY

What are today and tomorrow's challenges facing the Estonian economy? Filled with pride in the economic development of our country over the past decade, we must now concentrate more on the future. Estonia's goal is not only the sustainable economic growth target of 5.5-6 per cent per annum but also the preparedness to join the European Union and to make maximum use of the forthcoming opportunities. What should we focus on specifically then?

B.1 Challenges facing the Estonian economy on its way to the European Union - overall economic policy stance

The Estonian economy is already strongly integrated into the European economic area. From the perspective of the central bank I would like to emphasize the clear convergence of the interest rate fluctuations and inflation cycles in Estonia and the European Union.

Nearly 81% of Estonian exports go to current and future EU member states. In 1994-2001 Estonia's exports to the European Union increased by 25% per annum on average. They have steadily outgrown imports from the European Union. That means we have been steadily increasing our market share in the European Union, although that share is small. The export structure also characterises our competitiveness - exported goods reflect the changes that have taken place in the economy. Our traditional export items are timber, textiles and foodstuffs, but also include electric motor parts and components, cables, mobile phones, antennae and the like. However, we do not export only goods but services too - primarily transport and travel services, as well as computer and IT services. The volume of these services has been increasing rapidly during the last three years.

The FDI inflow, which has reached the 9 billion kroon level in recent years, proves our competitive position in the Baltic Sea region as well as beyond it. The equal distribution of investments between the main sectors of our economy is an indication of the balanced nature of our economic development (in 2001, for example, manufacturing industry - 20%, transport and communications - 23%, wholesale and retail trade - 14%). It is also important to note that FDI inflow was not contingent on the privatisation of former SOEs. Finally, our competitiveness is demonstrated by the yield of investments made in Estonia, as well as the reinvestment of a substantial part of annual profits, which in 2001 amounted to 3.8 billion kroons.

The readiness of the Estonian economy for integration with the European economic system is demonstrated especially well by such key sectors of our economy as the financial and telecommunication sectors. Here we talk about the complete opening up the markets to domestic and foreign competition, strong state supervision and the integration of Estonian enterprises with the big multinational corporations.

What should we focus on in the future?

Estonia is no longer a catchup candidate country as it was three or four years ago. However, we still cannot say that the restructuring of our economy has been completed. On the contrary, the forthcoming member status in the EU will mean many more responsibilities. Our goal is not simply to be ready for the EU accession but to ensure maximum use of the opportunities concurrent with that membership. What should we focus on most?

Firstly, a clear vision of the state's role in the organisation of the economic system is needed. The task of the state is not to produce goods or services. It is to ensure the functioning of the market wherever and whenever it requires support.

Secondly, unemployment has become a problem in Estonia. Without dwelling on concrete statistics, I would like to emphasise that the labour market is subject to the same set of rules as all other markets. If labour is too costly, entrepreneurs will not recruit new workers. I stress this fact because in recent years our political measures for the mitigation of unemployment have, as a rule, been driven by the so-called active labour market strategy - focusing mainly on retraining and further education. Although an active labour market policy is necessary to increase the mobility of the labour force, it can reduce unemployment only if the legislative regulatory framework and the overall structure of the labour market foster the creation of new jobs. I think that in Estonia we should seriously and comprehensively analyse the factors that influence employment, including absolute or relative taxation of the workforce and the costs related to hiring and layoffs.

Thirdly, balanced growth must be addressed. Reforms are not an objective per se, but we undertake them with the assumption that they will lead to a higher economic growth rate, increased higher income and an improved living standard.

Leaving aside the turbulent years of economic reforms immediately after the 1992 monetary reform, which lasted until 1995, the average annual economic growth rate in Estonia has been above 5%. Between 1995 and 2001 the average salary increased from 2086 kroons per month to 5721 kroons. During the same period real wages increased by one-third. We believe that our mean economic growth rate will continue to be about 6% per annum. The quality of economic growth in Estonia is consolidated by growing productivity - in 1995-2001 the GDP per capita (in fixed prices) increased by almost 40%. It is also demonstrated by the remarkable interest of the private sector and its readiness to invest. Structural changes in the economy can also be regarded as quality indicators; for example, changes in the distribution between the industrial, agricultural and service sectors.

Still, in the forthcoming years we must keep a watchful eye on the external equilibrium of our economy, the current account deficit and its financing, and changes in productivity and competitiveness. It is obvious that no country, not even Estonia, should assume, for example, an 8-9% current account deficit spanning several years when planning its economic policies. Even if the latter figure is financed through foreign direct investments during the initial years, the effect on the economy is inevitable. The slower economic growth is during the adaptation period, the more painful it is for society. The goal of the economic policy should be the prevention of an internal demand-driven boom immediately prior to and after the EU accession, which will then be followed by a significantly slower growth phase.

Pre-accession economic programme and macroeconomic risks

All these important issues are, to a certain extent, reflected in Estonia's pre-accession economic programme, which was recently approved by the government of the Republic. I want to stress that the projections which form the basis of the national pre-accession programme and the premise that the real total output of the Estonian economy is going to increase at the rate of about 6% per year are attainable only if the current economic policy continues. Maintaining macrobalance is of critical importance for sustaining the economic growth and credibility of the monetary policy. The kroon's fixed exchange rate and the forthcoming entry into the euro zone are by no means "free lunches".

B.2. Challenges facing the Estonian economy on its way to the European Union - internal policy - joining the EMU

Estonia's entry into the euro zone is contingent on the fulfilment of economic criteria applicable to the single currency countries. One can say that only those economies that meet the requirements can benefit from the transition to the single currency. Estonia's monetary and exchange rate policy during the pre-accession period and immediately after the EU accession should be considered against this background.

Firstly, the fixed exchange rate of the Estonian kroon against the euro and the currency board system will remain unchanged before and after the accession to the European Union. The adoption of the euro will take place in three stages in accordance with the acquis - joining the European Union, joining the ERM2 exchange rate mechanism and, once the Maastricht criteria are met, joining the euro area. The present condition of Estonia's economy and financial system, as well as integration with the EU markets that I commented upon earlier, in our view fully support this principle.

Furthermore, the European Commission and the European Central Bank have affirmed to us that the euro-based fixed exchange rate and currency board regime, in principle, are in harmony with the acquis and conform to the requirements set for the monetary policy of the non-euro zone economies.

Secondly, the ERM2 provides the new member states a necessary and useful interim stage between the EU accession and the adoption of the euro. The choice of monetary and exchange rate policies in the new member states has been diverse. The ERM2 is a suitable and flexible means for the harmonisation of the varied monetary policies and their applied tools.

The post-accession period will most likely be a serious test phase for most member states (definitely Estonia) in the intricate integration of their economic and fiscal policies and relevant co-operation with EU institutions. Participation in the development of economic policy guidelines sets relatively high demands both on actual policy formulation and institutional co-operation. Naturally this process will have two parties: the present applicant countries, which will be joining in the EU processes, and the "old" member states, which will be to studying the key problems the new member states face in their economic development. The post-accession ERM2 phase will be an appropriate time for the establishment of a comprehensive co-operative effort in the economic policy area on the national as well as the European Union level.

The "testing" of the economies' competitive abilities will also be crucial; not by means of their respective exchange rates but by their interest rates.

Maastricht criteria

For Estonia, like for all new member states, the only possible way of joining the euro system is to do it in full compliance with the letter and spirit of the EU Treaty. As we well know, the key issue here is the fulfilment of the Maastricht criteria. Most new member states, including Estonia, will obviously have no great difficulties in meeting the sovereign debt and budget deficit criteria. The remaining two criteria - low inflation and exchange rate stability - are connected with some specific problems.

The fulfilment of the inflation criteria might not in reality be as difficult as is feared and be achievable in the not so distant future. However, in the context of a rapid accession, the meeting of the inflation criteria becomes a major issue. This is due to the interaction of the so-called real and nominal convergences. Together with the rapid growth of productivity and earnings, prices are going to rise quicker in the new member states. Considering the great price gaps in applicant countries vís a vís the present member states, one can assume that price equalisation will take time. Thus, we can conclude that inflation rates in the new member states will stay higher than the mean rate of the three lowest inflation economies in the European Union plus 1.5 per cent for several years. We have estimated that for Estonia the "optimum" pace for the streamlining of prices would be ca 2 to 3 per centage points per year. In our opinion this difference reflects the trend of quicker productivity increases.

In conclusion, I wish to make a few comments on the main economic policy issues that the European Union faces. After the introduction of the euro the issue of potentially new co-operative modes has been raised repeatedly. This is also being discussed at the Convention on the Future of Europe. Figuratively speaking, the question asks which policy measures foster the best utilisation of the possibilities offered by the single currency.

C. CHALLENGES FACING THE ESTONIAN ECONOMY ON ITS WAY TO THE EUROPEAN UNION - THE EU PERSPECTIVE

Naturally,the first priority issue is the further improvement of the EU's internal market. The on-going convergence and improved operational efficiency of the internal market will make prices more flexible and allow for the better use of resources. It is extremely important to develop a common market for all goods and services, including telecommunication services and other utilities, as well as financial services, in order to ensure free competition and price formation based on the forces of supply and demand in the Pan-European market. For example, a well-functioning common market should help to reduce transaction costs by offering more and more services via the internet, provide a common innovative policy, maintain a system of business support measures and dissemination of the experiences of different businesses, and aid with the availability of start-up capital. All this is deemed necessary to promote productivity and further convergence.

Flexibility and mobility of production factors

Another set of critical issues is related to the flexibility and mobility of production factors. Here I must stress the importance of capital and labour market flexibility. Both need all possible support in order to increase the efficient use of resources in the common market economies. In addition to the unified money market in the euro zone, we should aspire towards the full integration of capital markets. Simplified procedures for the adoption of secondary legislation that regulates the financial services area are an important step forward. The convergence of financial markets calls for a more extensive harmonisation of the legal environment in various countries, but it also requires closer co-operation between the various national supervisory authorities and/or better co-ordination of supervision functions on the EU level. In addition, it should be taken into account that capital transfers between the member states will be easier if the business laws and regulations of different countries are harmonised. Here I could also mention rules governing companies' mergers and takeovers, bankruptcy procedures, and state aid distribution terms and conditions.

A flexible labour market is extremely important for effective common monetary policy purposes. However, it is unlikely that in the near future Europe will see any notable cross-border migration of the labour force - it is not expected to happen before or after the EU enlargement. Therefore, the limited flexibility of the labour market should be offset by an efficient internal market, high capital mobility and greater flexibility of the domestic labour market.

Fiscal policy - fiscal federalism

In addition to the above-mentioned supply-related issues, the EU and its member states' fiscal policy principles in the context of the common monetary policy have been under special scrutiny. It has been stated that enhanced co-operation within the fiscal policy area will allow for mitigation of the potential economic difficulties in various countries. In principle, the question is whether and to what extent automatic balancing mechanisms should be invoked on the EU general fiscal stance level and be targeted at the smoothing of regional disparities with automatic income transfers from the wealthier to the less-wealthy regions - thus, in fact, compensating for the lack of an exchange rate mechanism within the single currency regime. Furthermore, in recent months the question has been raised whether or not the requirements of the Stability and Growth Pact are too rigid.

By way of general comment, I should say that there are many examples of great disparities between the different regions of a given federal state. Regional policy is also crucial for states with high labour mobility. Ultimately, the success of regional economies depends primarily on the efficient management of resources, while extensive income transfers can even slow down the adjustment process.

In my view it is obvious that as long as the European Union remains an alliance of independent member states, there will be neither the need nor possibility for any additional communalization. Exceptions could include precisely defined circumstances when an intervention on the EU level would be justified in order to ensure the uninterrupted functioning of the internal market. The harmonisation of the fiscal policy on the macro level would be automatically accompanied by a tax rate equalisation. Taking that point into consideration, the taxation policies of any given member state reflect the principal choices of their internal policy and preferences of their society.

Stability and Growth Pact

With regard to the Stability and Growth Pact, it is assumed that automatic stabilisation mechanisms shall function smoothly within the 3% GDP scale. This threshold can be exceeded only in case of an abrupt or unexpected shock situation. Additionally, the Stability and Growth Pact aims at a balanced budget throughout the economic cycle. Thus, it presumes that one should not look for structural reasons if some member state experiences a long-term budget deficit or surplus. In my opinion, the Stability and Growth Pact has performed its function very well in recent years. This is proved by the fact that most of the EU member states now have a much stronger fiscal position than in previous years.

Any major changes in the Stability and Growth Pact are likely to cause additional insecurity and significantly affect the credibility of the entire framework. Therefore, I believe that the Stability and Growth Pact should continue to remain a cornerstone of the EU's economic policy in the years to come. Further convergence of markets and various national economies should by itself prop up the framework of the Stability and Growth Pact. In addition to the potential approximation of the business cycles, the common market should create preconditions enabling each country to invest its savings effectively within the Union. Even more importantly, harmonised and flexible commodity markets will help reduce adjustment costs, thus minimising the need to use budget stabilisation mechanisms during the short-term adjustment period.

D. CONCLUDING REMARKS

To date the European Union faces several complicated but well-known economic policy problems from its recent past. Estonia as a future EU member state must take this into account. It is not enough to be able to overcome challenges on the WAY to the European Union. We must become equal partners with other European states, be able and willing to participate in the discussions on monetary and fiscal policy issues, and perceive Estonia in Europe and Europe in Estonia. Today, the European Economic and Monetary Union, within which 12 states have adopted the single currency, offers a historic chance to create a truly strong, flexible and efficient economic area. I believe that the potentials of the single currency will be exploited in the best possible way. It will serve the interests of both the current and future member states as well as the whole of Europe.

V.Kraft. Challenges Facing Estonian Economy in the European Union