CHANGES IN THE STRUCTURE OF THE FINANCIAL ACCOUNT OF ESTONIA'S BALANCE OF PAYMENTS (1)

(1) The author of the present article Martti Randveer is an economist at the Research Department of Eesti Pank.

Introduction

In recent years external financing has become one of the most important factors affecting Estonia's economic development. Foreign investments into the Estonian economy have, on one hand, contributed to the increase of the production potential of Estonia. On the other hand, the transfer of production and business management know-how has accompanied foreign investments.

Due to the great importance of external financing in the Estonian economy, the article below is focussing on the main tendencies in the structure of the inflow of foreign capital from the early 1994 until the middle of 1999. The author has also tried to determine the factors that have influenced the inflow of foreign capital and its structure.

The first part of the paper summarises the major theories on international capital flows and the most important conclusions of the studies of this decade on foreign investments into developing countries. The second part looks at foreign capital inflows into Estonia from the point of financial instruments, foreign assets and liabilities, as well as institutional economic sectors.

1. Theoretical Aspects of Foreign Capital Inflows

The studies on international capital flows have focused on the following aspects:

  1. the volume and structure of international capital flows;
  2. factors influencing foreign capital flows;
  3. economic mechanisms explaining the international capital flows-related real transfers of resources between countries;
  4. impacts of international capital flows (The New Palgrave, 1998).

As the main goal of the present work is to analyse the structure of foreign investments made in Estonia between 1994 and the first half of 1999 and the factors influencing capital investments, we have looked into the theoretical aspects of foreign investments into emerging markets. As the structure of capital flows has changed considerably in the 1990s, the focus will be on the studies of the past five to six years.

At the same time it is clear that studies of foreign investments (2) into emerging markets draw on the basic theories of international capital flows. Therefore, the first part of this chapter will briefly introduce the theoretical concepts. This will be followed by a brief survey of the most important theories on foreign direct investments (3).

(2) The current paper treats as foreign investments both real investments and financial investments (eg made into debt securities of companies of emerging markets).

(3) Theories on foreign direct investments have to be treated separately because the factors influencing those capital flows differ greatly from the factors influencing portfolio and other foreign investments.

1.1. Theories on International Capital Flows

The theories explaining international capital flows can conditionally be divided into three groups - (1) flow theory, (2) stock theory, and (3) the monetary approach of the balance of payments.

According to the flow theory, international capital flow result from the differences in interest rates between countries. Under this theory the external liabilities of country A in a world consisting of two countries can be expressed as follows, all other conditions being equal:

FA = IA + fA(rA, rB)

where FA is the variable of external liabilities of country A (or capital flow), rA and rB are interest rates in country A and country B, and IA is a component of capital flows that does not depend on interest rates. It is presumed that [delta]fA/[delta]A>0 and [delta]fA/[delta]rB<0. Thus, the increase in domestic interest rates relative to interest rates abroad or the decline of interest rates abroad relative to domestic interest rates increases the inflow of foreign capital or reduces its outflow (Södersten and Reed, 1994).

In essence, this theory means that the difference in interest rates between two countries creates a continuous flow of capital between these two (4).

(4) This concept has, for example, been included in one of the best-known macro model of an open economy, the Mundell-Fleming model. Namely, J. Fleming (1962) and R. Mundell (1968) presumed that the difference of interest rates between two countries results in a constant capital flow from the country with lower interest rates into the country with higher interest rates.

Another important theory on international capital flows, the stock theory, is based on the portfolio theory developed by Harry Markowitz (1952) and James Tobin (1958) in the 1950s. The portfolio theory describes how profit-maximising private individuals diversify their assets between different investment opportunities. At that, profitability depends on the expected average return on the investment as well as the dispersion (5) of the profit rate. In this case, the optimal portfolio of assets is composed based on the level of risk the individual is ready to take (that is, the extent to which private individuals are prepared to replace the increase of profit earned from the investment with the increase of the variation of profit level) (6).

(5) Under the portfolio theory, economic agents in their choice of investment project also take into account the correlation of profit earned from different investments to other investment opportunities. All terms being equal, the lowering of the correlation of the profit earned from a given investment against the level of profit earned from another investment means the increase of the share of this investment (stock) in the portfolio of the investors.

(6) As a rule, private individuals are presumed to be risk averse. This means that in case private individuals have to choose between two investment opportunities promising similar average profits they prefer the one with a lower risk level (that is, smaller dispersion of the profit rate).

From the above we can conclude that at constant level of wealth of private individuals the difference in interest rates between countries does not result in continuous international capital flows. According to this theory, an increase in interest rates in one country, ceteris paribus, leads to a one-off change in the asset structure of investors - the share of the assets of this particular country in the portfolio of the economic agents increases. International capital flows will continue only until the portfolio of private individuals reach optimal structure.

However, it has to be noted that the theoretical concept of the stock of the capital account based on the portfolio theory does not exclude continuous capital flows between countries. This tendency derives from the fact that the expected average return of different assets influencing the structure of the optimal portfolio, the different dispersion of risks connected with it and the risk readiness of private individuals is constantly changing. As a result, the optimal asset structure of private individuals also changes over time and this takes place through international capital flows. Even if the factors affective the optimal structure of private assets remain unchanged, constant changes in private wealth can also cause continuous international capital flows.

In addition to the above two theories, international capital flows can also be viewed in the context of the monetary approach to the balance of payments. According to this theory, the surplus or deficit of the balance of payments is due to the lack of equilibrium on the money market. Excessive demand leads a balance of payments surplus and excessive supply causes the deficit. Thus, this theory explains external capital flows with the lack of equilibrium on the money market - excessive money demand results in the inflow of foreign capital and excessive supply results in the outflow of foreign capital (7).

(7) Here we have to take into account that the equilibrium in the money market can also be achieved by the current account transactions (eg excessive money supply can be eliminated through increasing imports).

As it was said before, the factors affecting foreign direct investments differ from the factors that influence other international capital flows. Although foreign direct investments depend on the average expected rate of return and the level of risk involved just as other foreign investments do, foreign direct investments are directly influenced by several specific groups of factors. These are first and foremost related to the market imperfections.

Foreign direct investments have been analysed in the context of the life cycle of a product (Vernon, 1966). According to this, the aim of direct foreign investments is to make use of the competitive advantage resulting from the development of a new product or production technology. When the product reaches maturity, direct foreign investments are made into developing countries in order to make use of their lower production costs. The explanatory power of this concept is supported by the fact that in recent decades numerous labour-intensive production processes have been transferred to developing countries.

Another theory to explain foreign direct investments is the theory of internalisation or creating a internal market according to which foreign direct investments are made in order to maintain control over technology and management know-how that enables one to develop an "internal market" uniting several countries. The theory of internalisation maintains that foreign direct investments are the result of a process where market transactions are replaced with intra-company transactions.

One of the most highly regarded theories on foreign direct investments is Dunning's eclectic theory (Dunning, 1977). This combines three theories explaining the motives behind foreign direct investments - the location theory, the industrial organisation theory and the internalisation theory. According to this concept, a company will make a foreign investment in case it has three kinds of advantages: (1) ownership advantages, (2) internalisation advantages and (3) location advantages. The ownership advantages include such factors as the company's special access to inputs and the opportunity to procure them cheaply, better access to the raw materials markets, the economies of scale effect, unique technology, a well-known trade mark and better human resources. The internalisation advantages result from such factors as distortions on the market of the end product and distortions on the market of production inputs. The advantages of location include natural factors (availability of natural resources, for example), economic factors (production costs, transport costs and the exchange rate, for example) and political factors (the fiscal policy of the host country and favourable terms of investment; Dunning, 1993). According to this theory, foreign direct investments are made only when the investing company has all three kinds of advantages described above, at the same time.

The above theories on international capital flows point out important factors influencing foreign investments. However, it is clear that the impact of those factors on investments made at different times into different countries is different. Therefore, an analysis of foreign investments into Estonia would more appropriately be based on studies of the factors affecting the structure and inflow of foreign investments into the emerging markets done in the 1990s (8).

(8) Here we have to stress that the studies referred to are mostly based on the theories explaining international capital flows we mentioned above. However, the contribution of these studies consists in outlining the main factors influencing foreign investments into emerging markets in the 1990s and evaluating the impact of these factors.

1.2. Foreign Capital Flows into Developing Countries in the 1990s

The sudden surge of foreign capital inflow into emerging markets in the 1990s has been thoroughly discussed in economic studies (9). Most studies conclude that the significant increase of the inflow of foreign capital derived from both internal and external factors.

(9) See, for example, Claessens (1993), Schadler, Carkovic, Bennett and Kahn (1993), Calvo, Leiderman and Reinhart (1996), Fernandez-Arias and Montiel (1996) and the World Bank (1997).

The main reason for the significant increase in foreign investments into developing countries has been the opportunity to diversify the asset portfolio and the hope to earn high returns from those investments in the long run (World Bank, 1997). According to the World Bank, these factors have also been enhanced by changes in the economic environments of the emerging markets and industrialised countries.

Positive structural changes as well as economic and political measures aimed at increasing macroeconomic stability in emerging market economies have boosted the expected yield on investments made into those countries in the 1990s. On one hand, these measures have improved the growth outlook of these countries as well as increased their international credibility (World Bank, 1997). Among the structural reforms in the emerging economics, liberalisation of foreign trade and capital account transactions and privatisation of state property have had most significant impact (10). The economic and political measures aimed at increasing macroeconomic stability have first of all lowered inflation and strengthened the fiscal situation of the public sector (11) (12).

(10) Obstfeld (1986) has emphasized that the inflow of foreign capital can be encouraged by the liberalisation of the domestic capital market.

(11) In the heavily indebted countries which in 1982 had run into serious difficulties in servicing their debts, the average inflation dropped from 77% in 1979-1989 to 19% in 1996, the average budget deficit decreased from 6% of the GDP in 1983-1989 to 3% in 1990-1996 and the total external debt was reduced from 54% of the GDP in 1990 to 37% in 1996 (IMF, 1998).

(12) Several studies have pointed out that macroeconomic stability is an important factor for investments. Schmidt-Hebbel (1995) has found that macroeconomic instability dampened the economic growth of emerging markets between 1960-1990 by 0.9 percentage points per year.

As it was already said, investments into emerging markets have also considerably increased in the 1990s due to the investors' wish to diversify their portfolios (13). This can to a certain extent be seen from the fact that as compared to the previous decades the share of portfolio investments into stocks in the structure of capital flows into emerging markets has increased sharply (14).

(13) See, for example, Gooptu (1993).

(14) The desire of investors to diversify their portfolios internationally is first of all expressed by portfolio investments into stocks.

Here we have to note that diversification of portfolio risks has become an important factor for investments into emerging markets only in the current decade. On one hand, this has been facilitated by the development of the capital markets of developing countries (15). On the other hand, this tendency has been encouraged by the low correlation between changes in the yield from investments into emerging and industrialised countries (World Bank, 1997).

(15) For example, in the index of emerging markets (IFCI) compiled by the International Finance Corporation (IFC) the combined capitalisation of 18 developing countries in 1996 exceeded the 1985 level by approximately 14 times.

The impact of the factors described above has been considerably strengthened by the changes in the economic environments of both the emerging and industrialised countries in the 1990s. Namely, structural reforms (privatisation, liberalisation of current and capital account transactions and reduction of state regulations on investments) have considerably improved the access of foreign investors to the markets of these countries. In the developed countries, on the contrary, the tighter competition in the domestic market combined with the declining transport and communication costs have encouraged the companies of these countries to expand their production into developing countries. As a result, direct investments into emerging markets have increased considerably. The liberalisation of the financial markets and abandoning of restrictions on capital account transactions in the developed countries in the 1980s and 1990s have also facilitated foreign investments by investors of the industrialised countries (16) (17).

(16) See, for example, El-Erian (1992).

(17) According to the World Bank estimations, investments (mostly portfolio investments) into emerging markets have also been supported by the growth in the share of institutional investors.

It is generally believed that foreign investments into emerging markets have also been facilitated by the decline in nominal interest rates in the industrial countries in the 1990s (18). In 1987-1990 the average short- and long-term interest rates were 7.3% and 8%, respectively, while in 1994-1996 the respective rates stood at 4.3% and 6% (IMF, 1997).

(18) See, for example, Calvo, Leiderman and Reinhart (1993), Fernandez-Arias and Montiel (1996).

The crisis in the Southeast Asia that began in the summer of 1997 has also pointed to the possibility that the inflow of foreign capital into emerging markets to a considerable extent resulted from market distortions. In case of foreign direct investments the role of market distortions (for example, the projectionist policy of the government) has been proven, while in case of portfolio and other investments made by the private sector, market distortions were thought to play an insignificant role until the outbreak of the Southeast Asian economic crisis.

Recent studies (19) have outlined two market distortions that could have affected portfolio and other investments into a number of emerging markets. Firstly, several developments in the Southeast Asian countries indicate that there were herding among foreign investors. Therefore, the increase of capital investments into some emerging markets could have been just a reflection of the investors' irrational behaviour. Secondly, the increasing volume of foreign capital inflow into emerging markets could also have been the result of a strong moral hazard. The moral hazard resulted, first of all, from the widespread practice of government intervened to rescue financial institutions. If creditors (foreign investors, for example) presumed the continuation of such an economic policy, this market distortion could have encouraged the inflow of foreign capital.

(19) See, for example, IMF (1998).

2. Structural Changes in Estonia's Financial Account from 1994 to the First Half of 1999

2.1. Direct Investments

In the period under scrutiny direct investments have been one of the major sources of foreign capital inflow into Estonia (see Figure 1 ). Direct investments were of particular importance in 1994 and 1998 when they amounted to 125% and 117% of the surplus of the financial account of the respective year (see Table 1). Foreign direct investments played and important role also in 1998 and the first half of 1999, accounting for 80% and 95% of total foreign capital inflow. In the period under study, foreign direct investments amounted to approximately 55% of the surplus of the financial account of the period. Besides satisfying the domestic demand for investments, foreign direct investments have helped to considerably boost the level of production technology and business management of Estonian companies.

In the period in question foreign direct investments made in Estonia have fluctuated considerably (see Figure 2). In 1996 foreign direct investments formed EEK 1.8 billion, while in 1998 the respective figure rose to EEK 8.1 billion. At the same time, the structure of direct investments changed (see Table 2). For example, ever since 1994 direct investments made by foreigners into the equity capital of the newly established companies have been on the decline. In 1994 these accounted for nearly a quarter of total direct investments made in Estonia, while in 1998 this kind of investments made up less than one per cent of the total volume. A somewhat similar trend could be seen in 1994-1996 when the share of direct investments into the equity capital of companies was constantly declining. In 1997 direct investments into equity capital began to grow. In 1996 such investments made up 12% of total foreign direct investments into Estonia, while in 1997 their share increased to 37%, in 1998 to 70% and in the first half of 1999 it stood at 34%. In addition to these changes, loans granted to Estonian subsidiaries and affiliated companies by their foreign parent companies have become one of the most important ways of direct investment financing since 1995.

As compared to 1994 and 1995 the following two years saw a remarkable decline in the share of direct investments. In 1996 and 1997, for example, direct investments made up just 21% and 16% of the surplus of the financial account of the respective year. Formally, this tendency reflected the intensification of the inflow of other investments and a considerable increase of direct investments from Estonia into foreign countries. In 1998 and in the first half of 1999 the absolute volume of direct investments and their share have increased despite a certain decline in the inflow of foreign capital.

As it was already mentioned, 1996 and 1997 showed a sudden increase in the direct investments made by Estonian companies into foreign countries. In 1994 and 1995 these capital flows had amounted to approximately EEK 30 million in both years, while in 1996 and 1997 the respective figures were EEK 485 million and EEK 1.913 billion. The increase of direct investments abroad resulted, on one hand, from the strengthening of the economic positions of Estonian companies. On the other hand, this rapid development can also be attributed to the improved access to local and foreign credit resources. This conclusion is supported by the fact that when access to credit resources became more limited in 1998 and the first half of 1999 and Estonia's economic situation deteriorated, direct investments from Estonia abroad fell sharply, amounting to EEK 82 million in 1998 and EEK 212 million in the first half of 1999.

In the period in question the volume of foreign direct investments made into Estonia was mostly affected by domestic factors. Capital investment was to a considerable extent facilitated by the positive effects of structural reforms and measures aimed at achieving macroeconomic stability. Among economic policy measures the most important was probably privatisation which significantly widened the investment opportunities for foreign investors. The active involvement of foreign capital in privatisation also derived from the method of privatisation chosen by the government. As the aim was to develop a group of owners who would possess enough resources for reconstructing the companies and guaranteeing their effective management, the majority of state companies were sold to core investors. As residents had few financial resources in that period and access to credit was relatively limited, the sales price of privatised companies was not very high. Thus, foreign direct investments into privatised companies were encouraged by relatively high-expected return.

Besides the fact that the privatisation process was nearly finished, the relatively small share of direct investments in 1996 and 1997 could also have been the result of a fact that until 1993-1995 foreign direct investments had been one of the most important ways of attracting long-term capital. That period was characterised by the low level of foreign portfolio and other investments as well as the conservative lending policies of commercial banks. As a result, the companies' opportunities of attracting long-term capital were fairly limited. Due to the increase of foreign capital in 1996 and 1997 (mainly in the form of portfolio and other investments) and the increased confidence of residents (including banks) in the success of economic development, the access of the Estonian corporative sector companies to long-term loans of Estonian commercial banks improved. In 1996 and 1997 various companies of other economic sectors also had the opportunity to obtain long-term external resources directly on the international financial market. Despite the fact that the number of such companies was small, the loans taken and the worth of bonds issued by them were relatively large. Therefore, we can say that demand for foreign direct investments in 1996 and 1997 was not as high as in earlier years. Due to the decline in the inflow of foreign capital in 1998 and the first half of 1999 (which mainly concerned portfolio and other investments) and the decreasing risk aversion of local banks, the demand for foreign direct investments increased again. Also, the high level of direct investments in 1998 and the first half of 1999 could have derived from the fact that the problems that hit the Estonian economy had no significant impact on the growth potential in the medium and long-term perspective.

On the other hand, in the post-monetary reform period the companies of the Estonian corporative sector were characterised by relatively obsolete business management and production technology. As in most cases investments made by companies from developed countries also entailed the transfer of economic and production know-how, the capital investments of that period were highly productive. Due to the fact that the relatively rapid economic development has improved the level of business management (and to a certain extent also the technological level) of Estonian companies we can presume that in most cases the transfer of know-how linked to foreign direct investments produces a smaller effect than in the years 1992-1994 (1995). The described tendency may thus partially explain the fall in the volume of foreign direct investments in 1996 and 1997.

In the past two-three years there have been several studies based on the polling of foreign investors who have made direct investments into Estonia. The poll results indicate that the most important factors influencing foreign direct investments into Estonia have been access to new markets (Hirvensalo and Hazley, 1998; Varblane, 1998, and Glaros, 1996), expansion of the company and trade (Glaros, 1996) and widening of the market, convertibility of the kroon, free movement of capital, the prospect of the eastern market and rapid economic reforms (Varblane, 1998).

2.2. Portfolio Investments

In case of portfolio investments the period in question can be broadly divided into two (see Figure 3 ). In 1994 and 1995 the balance of portfolio investments was negative, while from 1996 to the first half of 1999 they accounted for 29% of the surplus of the financial account of the same period (see Table 3 ). The low level of portfolio investments in 1994-1995 was the result of the underdeveloped stock market as well as the limited access of Estonian companies to international capital.

The significant increase in the volume of portfolio investments from 1996 onwards can first of all be attributed to the rapid development of the stock market. That year marked the improvement of the institutional framework of the stock market as well as growth in the liquidity of the market. In 1997 the large inflow of portfolio investments reflected the considerably improved access to international financial markets by financial institutions (mainly banks) and several companies of the corporative sector. This tendency resulted, first of all, from the growing international confidence in the Estonian banking sector. Besides the above, intensive inflow of portfolio investments in 1997 can also be attributed to the significant increase in the demand for foreign capital in the second half of the year. In 1996 and the first half of 1997 the tendencies described above were also positively influenced by the low interest rates in Western Europe and the optimistic expectations of international financial markets on the economic development of the countries in transition. The big share of portfolio investments in the first half of 1999 was first and foremost related to the privatisation of Eesti Telekom (Estonian Telecom).

As compared to the first three years of the period in question, in 1997 there was a sudden surge in the portfolio investments made by Estonian residents into foreign countries. Such portfolio investments amounted to approximately 3.5% of the 1997 GDP. The growing inflow of foreign capital and the increase of the residents' risk readiness encouraged this tendency.

From 1996 to the first half of 1999 the structure of portfolio investments has undergone several changes. In 1996, 1998 and the first half of 1999 portfolio investments arrived mainly in the form of investments into stocks, while in 1997 investments into debt securities dominated among foreign portfolio investments. The high level of investments into debt securities must have reflected the growing reliability of Estonian financial institutions, which improved their access to the international financial markets. Changes in the volume of portfolio investments into stocks in 1996-1998 partly also depended on the changes in stock prices on Tallinn Stock Exchange. In 1996 portfolio investments made into the shares of Estonian banks exceeded EEK 1 billion, while at the peak of the stock market in the third quarter of 1997 foreign investors sold shares for almost EEK 600 million. As we already mentioned, the high level of portfolio investments in the first half of 1999 derived from the privatisation of Eesti Telekom.

2.3. Other Investments

In 1994-1996 the share of other investments in the inflow of foreign capital increased. In 1994 the outflow of other investments exceeded their inflow by EEK 375 million, while in 1995 the net flow of other investments (EEK 815 million) amounted to 29% of the surplus of the financial account (see Table 4). In 1996 and 1997 the respective figures were 51% and 50% of the financial account surplus. In 1998 and the first half of 1999 the situation was reversed - the outflow of other investments exceeded their inflow by EEK 1.1 billion and EEK 2.3 billion, respectively.

Like in the case of portfolio investments, the inflow of other investments, too, surged considerably in 1996-1997 (see Figure 4). Presumably, the factors behind it were mostly domestic. In addition to the factors mentioned above, the increase of capital flows was also encouraged by the low interest rates in Western Europe and the deepening confidence in the future development of transition economies. In the second half of 1997 the intensive inflow of foreign investments also reflects the significant rise in the demand for foreign capital.

As we already mentioned, the outflow of foreign capital in the form of other investments took place in 1998 and the first half of 1999. Like the decline in portfolio investments made into debt securities the drop in other foreign investments resulted from the weakening confidence of foreign financial markets in emerging economies. This limited considerably the access of Estonian financial and other sector companies to international loan resources. In 1998 the low level of the net flow of other investments can also be attributed to the fact that in the second quarter Estonian banks had to repay approximately EEK 1 billion worth of earlier loans. In addition to this, the outflow of other investments also reflected the toughening of the credit policy of the local banking sector.

Similarly to direct and portfolio investments, 1997 also saw the sudden surge in external claims in the form of other investments which amounted to EEK 4.6 billion. Like in the case of other foreign capital flows the growth of external claims through other investments was influenced by the improved access of the financial sector to the international financial markets. The increase of these external claims partially derived from the increase of the foreign trade turnover (as a result, the claims of residents in the form of trade credit rose to EEK 0.85 billion) as well as the growing loan supply due to the increasing inflow of foreign capital (in 1997 banks lent EEK 1.15 billion to non-resident companies) (20).

(20) Part of these companies were probably the offshore companies owned by residents.

2.4. The Government Sector

From 1994 until the first half of 1999 the government sector attracted relatively little external resources as compared to the other sectors of the economy. External financing of the public sector expenditures was at the highest level in 1995 when it amounted to 1.5% of the GDP and accounted for slightly over 20% of the surplus of the financial account that year. In 1994 and 1996 these figures were somewhat smaller. In 1997 and 1998 and in the first half of 1999 the government sector funds placed abroad and repayments of foreign loans taken in earlier periods exceeded the inflow of foreign capital into the government sector.

As in the period in question the central government has not used foreign loans to cover current expenditures, the extent of the external financing of the public sector has been influenced the most by investment decisions of the central government and local governments financed from foreign resources (mostly loans). In 1994 and 1995 the external borrowing of the government sector was linked to financing of the central government investments. But since in 1996 the city of Tallinn had an opportunity to raise external financing through a bond issue, the foreign capital attracted to the government sector that year was mostly connected with the significant increase of investments in the capital city.

Since the second half of 1996 the government sector has clearly reduced the role of foreign capital. On one hand, the limited use of foreign loans points to the central government's wish to keep the growth of the debt burden under control. On the other hand, the role of the Estonian banking sector in attracting foreign resources to meet the demand for domestic investments has been increasing since the first half of 1996. This has reduced the demand for foreign loans taken by the central government. In the second half of 1996, in 1997 and in the first half of 1998 the low external financing of the public sector can also be attributed to the strong fiscal position of the government sector. Together with income from the privatisation of Eesti Telekom it has sharply increased the foreign deposits of the central government since the fourth quarter of 1997. At the end of the first half of 1999 the central government's foreign deposits amounted to EEK 2.8 billion. However, with the deterioration of the fiscal situation of the government in 1999 the volume of these external claims has been declining since the third quarter.

In Conclusion

The sharp increase in the inflow of foreign capital into emerging markets in the 1990s resulted from both internal and external factors, according to the majority of the studies devoted to this topic. Among the internal factors the most important has been the positive impact of the structural reforms and economic policy measures aimed at achieving macroeconomic stability in these countries. Among the external factors the biggest impact has come from the decline of nominal interest rates in the majority of developed countries and changes in the economic environment of the developed countries (for example, liberalisation of the financial markets of these countries, abolishing of restrictions on the capital account transactions, increase in the share of institutional investors).

From 1994 until the first half of 1999 Estonia has been characterised by an intensive inflow of foreign capital. In 1994-1997 the share of direct investments in total foreign investments decreased. Since 1998 the reverse has occurred - the role of foreign direct investments has increased considerably, while the role of other foreign capital flows has diminished.

Foreign direct investments have been mostly affected in this period by internal factors. According to foreign investors, the most important factors motivating investment decisions have been the prospects of entering a new market, the potential growth of the market, rapid economic reforms and free movement of capital. Among the economic policy steps, privatisation has been of major importance.

Foreign portfolio and other investments have been influenced in this period mostly by institutional changes (the launch of the Tallinn Stock Exchange, for example) and growing international confidence in the financial sector. In 1996 and 1997 these capital flows were also supported by the low interest rates in Western Europe and the optimism of the international financial markets about the outlook of the transition countries.

Martti Randveer

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