Vahur Kraft: A successful Estonia - in a successful Europe
Speech by Mr Vahur Kraft, Governor of Eesti Pank (Bank of Estonia), at the Euro Conference of Eesti
Pank, Tallinn, 3 May 2004.
* * *
This year spring is going to be different,
chirp-chirp! Different, this year different...
These are the words by Henrik Visnapuu, an Estonian poet, in his third letter to his beloved Ing in May
1919.
May has been a month of important events in the history of Eesti Pank. 85 years ago, on 3 May 1919,
the first entry regarding the fixed capital of Eesti Pank was made into the general ledger, and the first
payment was accepted into the current account. Thus, 3 May 1919 was the actual day the doors of the
Bank opened. (By the way, the historical entry into the general ledger can now be viewed at the
Museum of Eesti Pank.)
Today, on 3 May 2004, Eesti Pank made its first share capital transfer to the European Central Bank.
Eesti Pank has become a member of the European System of Central Banks, one of the owners of the
European Central Bank. Today, 3 May 2004 is already the third day of being a fully-fledged member
state of the European Union. Two out of three Estonian citizens voted for accession to the
European Union in the referendum held last September.
This is largely up to us. Becoming a member of the European Union
What is going to happen now?
does not mean that Estonia has become 'ready'. Every other Estonian resident believes that by
becoming a fully-fledged member of the European Union, Estonia will be able to influence the
decisions of the European Union in the future. Having faith in the possibility to influence
decision-making largerly shapes the attitutes of Estonians regarding the European Union as a whole.
The Estonian country and society have changed profoundly during the past 10-15 years -
maybe even faster than we would have believed, and others would have expected us to change. Does
anyone still remember that in 1992 the inflation rate in Estonia stood at 1,077 per cent? In 2003 prices
rose by just 1.3 per cent. In place of long waiting lists for having a telephone installed, Estonia has
evolved into a country enjoying one of the best communication networks in Europe with diverse mobile
telephony and Internet solutions, with active use of such facilities surpassing that of many European
Union member states. The daredevil slogan of 1988, 'An Independent Estonia to the 1992 Olympic
Games', has been replaced by actual membership not only in the Olympic family or the UN, but also
by full membership in the European Union and NATO...
•
On the 80th anniversary of Eesti Pank five years ago I spoke about the broader economic
policy role of our central bank. The right and obligation of the central bank to contribute to
shaping Estonia's economic policy has been set down in the Bank of Estonia Act. But this
task can only be performed in cooperation with the Government and other constitutional
institutions. Today we can acknowledge that regardless of the fact that both the central bank
and other state institutions employ Estonians who are known as great individualists, our
cooperation in the field of economic policy has been smooth and yielded results.
•
Five years ago I also spoke about the essential developments and necessary reforms facing
Estonia. Today, many structural reforms under discussion at the time have been successfully
launched, including the pension system reform, which has given a completely new
dimension to the saving patterns of the Estonians. As regards the changes that the financial
system was facing, my anniversary speech mentioned the plans to set up a universal
financial supervisory body, which has also successfully materialised. Today we have a
banking sector that is very up-to-date and successful on the international banking scene as
well.
•
According to the World Economic Forum, Estonia is the most competitive country today
among the new European Union member states with its competitiveness index of
4.64 points. With this score Estonia is also ahead of four 'old' member states (Spain - 4.47,
Italy - 4.38, Portugal - 4.25, and Greece - 4.00), while narrowly falling behind Ireland (4.69).
Our open market economy, development of the information society and the financial sector
as well as the quality of our business environment have been considered Estonia's strongest
areas.
•
In conclusion we can say that Estonia has been quite successful so far.
For a successful future, we should first realise how far Estonia has progressed. Then we can decide
where Estonia wants to be headed. When we know what we want to achieve in the future, we have to
answer another, often an unpleasant question: how, through which measures, and at what price can
we achieve the desired result? And then there is nothing more to it but to embark on taking purposeful
action... It is as easy as that. Or is it?
• It is a fact that as Estonia is evolving into a 'boring and stable European country', our society
is supporting change for the sake of itself less and less. Stability, keeping one's word, and
honouring contracts concluded either directy or indirectly is becoming an increasingly highly
regarded value in the Estonian society.
•
As Governor of Eesti Pank I would hereby like to recall that if anyone in Estonia has the
right - and obligation - to stress the importance of stability, it is the central bank.
Some very successful examples illustrating the fact that stability is held in high regard are
the Estonian kroon that has held out splendidly for twelve years and the Estonian monetary
system that has not been 'copied from Europe' but has been structured bearing in mind our
specific situation. The fact that we have been wise enough to keep to our principles also in
tougher times, and that we have not succumbed to the temptation 'to try something better'
when times have been easier has in the end only benefited the Estonian economy.
•
Today, the central bank maintains that considering the specific conditions and related
changes now that Estonia has become an EU member state, our agenda for the
coming years should include an upgrading of our monetary system to be completed
with the changeover to the euro. Namely upgrading, not a radical monetary reform: the
Estonian kroon will maintain its value, and the central bank will continue to exchange it at a
fixed rate for euros without any time or quantity restrictions. This promise is as binding to the
central bank as the word given in June 1992 that from that day on it was possible to
exchange eight Estonian kroons for one German mark every single day.
•
By June at the latest, the central bank will announce a competition for finding the
design for the national side of the euro coin. As we all know, there are altogether eight
euro coins. The side with figures is identical everywhere while the other side is different in all
member states. The look of Estonia's euro coins will become clear this year. To find the best
solution, Eesti Pank wants the Estonians to have a say and a right to decide the matter.
•
As of 1 May 2004, ALL new member states will have to treat their monetary and exchange
rate policy as an area of common interest for all member states. Price stability is the main
aim of Estonia's monetary policy already now, and it MUST remain so also according to the
principles of the European Union. But as far as the choice of strategies for managing the
monetary and exchange rate policy is concerned, this will still be decided by each member
state individually.
•
Therefore ALL the countries joining the European Union together with Estonia face another
important merger in the near future - accession to the Economic and Monetary Union (prior
to that the countries are EMU members with limited rights). Only after completing this
change can we be sure that our state is capable of fully utilising the possibilities that the
merger with a powerful economic area offers. Estonia hopes to be among the very first
member states to do that.
•
At some forums outside Estonia we have been asked why we are rushing to the euro zone.
Actually, the question should be formulated the other way round - why are some countries
incapable of taking this next step in the near future? Estonia has pursued conservative
economic policy and achieved success. Thus it is inappropriate to imply that we should wait
for others for whom our pace of movement is too fast. The changeover to the euro does
not call for extensive reforms in Estonia, rather, it is a more exhaustive utilisation of
the opportunities Europe has to offer.
•
The changeover to the euro cannot and must not be a seasonal election issue but an area
where we proceed from Estonia's interests - hence, common sense, analysis of the
economic situation, and knowledge of the theoretical foundations of the EMU.
•
The European Central Bank has indicated that due to the differences in the economies of the
new member states, a single approach suitable for everyone for joining the exchange-rate
mechanism, ERM II, and adopting the euro cannot be suggested. Besides, a common
approach was not possible for the present member states either. An approach that takes
into account Estonia's particulars means that accession is going to be based on the
present currency board arrangement and that our application to join ERM II will be
submitted as soon as possible. Prior to adopting the euro a country has to be a successful
member of ERM II for at least two years. Also Estonia's technical readiness for changing
over to the euro should be achieved by mid-2006. If such a scenario materialises, we will be
among the first new EU members to adopt the euro. I would like to stress that being among
the first is not an aim in itself but arises from the acknowledgement that Estonian economic
fundamentals have stood firm and that our economy will be ready for joining the mechanism
in a few years.
•
Joining the Economic and Monetary Union is a crucial step for the Estonian economy,
which will secure the sustainability of a favourable investment climate and strengthen
the prerequisites for a continued long-term and balanced economic growth;
•
The estimates by foreign investors and rating agencies on the reliability of Estonian
economy have already taken into account the imminent membership of the EMU,
which is evidenced by the interest margins and credit ratings that are already on the
levels comparable to the old member states;
•
A prerequisite for sustaining the outstanding reliability achieved to date is as fast as
possible changeover to the euro, i.e. becoming a full member of the Economic and
Monetary Union.
An important argument in favour of a comparatively swift changeover to the euro is Estonia's
current economic situation. What are the grounds for such a claim? In order to evaluate the broader
economic impact of joining the euro system and choose the right accession moment, the UK has
adopted five 'euro tests'. These are the following:
1. Have the economic structures and cycles of the accession country and the euro zone
converged sufficiently for a successful application of the common monetary policy?
2. Is the economy flexible enough to accommodate country-specific economic problems and
unexpected shocks that do not affect the whole euro zone?
3. Will joining the euro zone create better long-term investment conditions for companies?
4. How would joining the euro zone affect the financial sector?
5. Will joining the euro zone promote economic growth, economic stability, and long-term
employment?
Estonia scores five out of five on these tests.
The European Union gauges an applicant country's readiness for successful participation in EMU
according to the Maastricht criteria (inflation, interest rates, exchange rate, budget balance, and public
debt criteria).
•
The Estonian economic situation today is in many ways unique compared to the other
the inflation rate is low - 1.3% in 2003; Estonia is one of the few new
accession countries:
members states where the state budget balance is under control; public debt is one of the
smallest in the EU; and the exchange rate of the Estonian kroon has been fixed against the
euro for some time already.
•
Still, meeting all the Maastricht criteria requires major efforts also from Estonia. Difficulties
might arise both from the ideosyncrasies of the Estonian economy as well as from the results
of economic policy decisions.
• From the standpoint of the Maastricht criteria, the greatest peculiarity of the Estonian
economy is the comparatively low level of income, but on the other hand, the country ́s
economic growth is faster compared to the current EMU member states.
• Estonia's GDP per capita currently amounts to about 42% of the respective EU
figure; Estonia ́s price level is about 56% of the EU level.
•
Meanwhile, according to different studies, Estonia ́s potential GDP growth is 5-6%
per year - in a situation where the pace in the EU would be 2-2.5% per year.
• If the current growth rate differences are maintained, the level of income in Estonia should
reach the current EU average in some 20 years. Hence - the average price level will be
reached in the course of the following decades, not in months.
•
However, as many as every fourth Estonian believes that on account of the
changeover to the euro the prices will rise fast, which will have a significant impact on
their welfare. These people are worried about their primary subsistence - above all, growth
in food and housing costs is feared. I can assure you - based on the experience of other
countries - that the adoption of the euro in itself will not bring about any price rises. It is a
different matter that people sometimes perceive rises in prices to be steeper than they
actually are, e.g. if a cup of coffee at one's favourite corner cafe becomes more expensive.
Namely such rises contributed to the price growth after the changeover to the euro.
According to studies, adopting the euro cash boosted the inflation rate ACTUALLY only by
0.1-0.2 percentage points. Even if we compare the price increase in the year of the final
changeover to the euro, i.e. in 2002, to the inflation rate in earlier years, we can see that the
price rise in the euro zone did not accelerate. The rate of inflation in neighbouring Finland
was even lower than in 2000 or 2001. Meanwhile in Denmark, which had postponed the
changeover to the euro, growth in prices accelerated and was even faster than in Finland,
which had adopted the euro.
•
Unsubstantiated price rises under false pretences in the conditions of market economy are
above all prevented by competition between companies, both in Estonia and in the 'old'
Europe. In the 'old' Europe, also consumer protection agencies have been of help, which will
hopefully be the case also in Estonia.
• Administrative rises in excise duties related to the accession to the European Union and
increase in the prices of a few other individual goods (such as sugar) cannot and
These two
must not be associated with the adoption of the euro as a single currency.
factors are not related, except for the fact that in order to adopt the euro a country has to be
a member of the European Union first.
•
The following six months will indeed bring about several one-off price rises related to the
accession to the European Union - all in all, according to our current analysis, these
should escalate Estonian consumer prices 1-1.4%.
•
But none of these price rises is even slight related to the fact whether and when
Estonia adopts the euro in the future.
• In the conditions of market economy, price stability does not mean that prices do not change
at all, but that they fluctuate moderately and that price movements can be anticipated. The
price of sugar may slightly rise or fall both in Estonia as well as elsewhere in the European
Union in the future.
It is most likely that a piece of meat on the dinner table here in Estonia will at the time of
adopting the euro cost more than today. It is integral to market economy that inflation goes in
line with the increase in income. But the price will not rise due to the fact that the
denomination of payment is the euro and not the kroon. It will be so because the incomes of
people will have gone up and they can afford more and better goods. One thing is sure
- there is going to be a rise in the standard of living. It is the pace of growth that is the issue
here. And the European Union will significantly contribute to the increase in our income.
Next I will provide a more general background to the coming developments in Estonia.
In the past few years it has been customary that every
Why is the European Union useful to us?
regular quarterly economic survey of Eesti Pank includes a reference to the economic standstill in
Europe. But today I would like to stress that even as such, at a standstill, Europe's economic power
and extensive market suffices for it to remain one of the most important engines of the global
economy.
It is difficult to overestimate the role of the European Union in the world trade. One can, of course, be
ironic about some fruit standards but, meanwhile, the same EU standards and product safety
requirements affect the rest of the world. It is worth mentioning once again that 80% of Estonia's
exports go to the EU member states while 85% of the direct investments made into Estonia are related
to the European Union. I think that this calls for no further commentary.
Europe's core economic policy goals are embodied in the Economic and Monetary Union. Such
goals are stable economic growth and price stability. And this is what we all want. The EMU
signifies the common monetary policy and coordinated economic policy.
• Why a common monetary policy and a single currency? The aim of the common
monetary policy is to guarantee a low level of inflation (below but close to 2% a year) through
a common currency, a common central bank system, and common interest rates. Several
studies and decades of experience in the industrial countries have shown that a stable, low,
and easily predictable inflation rate leads to the most favourable conditions for long-term
economic growth.
•
The notion of a monetary union is based on the optimum currency area theory formulated by
Robert Mundell in the early 1960s. Multilateral fixing of currency rates and joining of
monetary policies offers several benefits:
•
excessive fluctuations in exchange rates, i.e. in the price of money will disappear; it
will be easier to predict the price of money in the future and therefore, easier to
plan the future;
•
improved certainty will reduce the cost of hedging currency risks and will avoid
such undesirable developments like the ones in Estonia that accompanied the
Russian crisis in mid-1990s; the costs related to currency exchange can, of course,
only be eliminated by a common currency;
•
most importantly, pegging the currencies should lead to faster economic and
financial integration, boost the flow of goods between countries, and enable
convergence of market interest rates and improved price comparison.
•
An additional advantage of a large currency area is greater seigniorage income earned on
issuing bank notes, since the money can be used outside its own economic zone. The role
of the euro as an international financing, settlement, and reserve currency has been
consistently growing. For example, of all the bonds issued in foreign currencies by world
governments and the private sector, bonds denominated in euros accounted for more than
30% in 2003 (prior to launching the euro the overall amount of the bonds denominated in the
national currencies of the current euro zone totalled 20%). The share of the euro in the
currency reserves of the world amounted to some 19% in 2003.
•
The larger the common currency zone is, the smaller the transaction costs, and the more it
will support economic development, increase stability and future security.
• Whether joining the monetary union is useful depends on the ratio of the costs of the lost
monetary policy independence to the gains arising from the accession. Since the exchange
rate is not an adaptation tool in the monetary union, prices and salaries must be flexible and
factors of production (capital and labour) have to move freely. In general terms, open
economies (and Estonia is a very open economy) and countries with similar economic cycles
gain more from the monetary union.
•
Why coordinated economic policy? Coordinated economic policy must contribute to
creating a favourable environment for stable and sustainable economic growth.
•
The most closely coordinated area between the EMU member states and institutions is the
budgetary policy. This is based on the framework established by the Stability and Growth
Pact: the budgets of the member states must be balanced or show a surplus during at least
several consecutive years and in no year must the deficit rise above 3% of the GDP. Besides
budgetary policy, most other economic policy sectors (e.g. labour market policy, structural
policies, etc.) are coordinated between the members states and institutions.
• The economies of the European Union member states are closely intertwined. Of the
external trade of the EU, some 65% is with other member states, and only a third with the
rest of the world. The more the economies of the member states depend on each other, the
greater the gain arising from the single currency. Then it will also be unlikely that economic
growth in some member states might be significantly slower, which could potentially threaten
the stability of EMU.
What does such a framework mean for the future of the European Union? Above all, economic
success of the European Union - hence also of Estonia - depends on whether the economy in Europe
manages to be sufficiently flexible and competitive so as to utilise the opportunities offered by the
single currency and attract more investments than before.
•
Economic flexibility is the trump card Estonia as a small country holds in the
European Union. It is very important for our small and open economy that the
powerful common market we are joining would operate as efficiently as possible and
that a climate favouring innovative ideas would be predominant in Europe. According to the
economic theory, the aim of the economic policy of a small country is to react fast in the
changing circumstances and respond to the changes in the global economy in time. Our
Estonian experience confirms this economic principle. The first prerequisite for a flexible
economy is the faith in the durability of the core values of economic policy. This means
abiding by the law and the fact that contracts are honoured and ownership relations stable. It
certainly involves faith in the stability of the currency. The latter in turn is inseparably linked
to the reliability of the financial system.
•
Another prerequisite for flexible economy is education and openness to new ideas.
•
Flexible economy also requires a favourable public attitude towards entrepreneurship.
Entrepreneurs must have the opportunity to implement their ideas and engage capital,
labour, and information at a fair market price and with as little trouble as possible.
• To sum up what has been said above, we could say that creating a flexible and competitive
economic framework is the main economic policy task for Estonia. With this task we would
also adopt the principal viewpoints of the Lisbon strategy comprising the economic policy
priorities and directions for development in the European Union today. The economy policy
priorities specified for the years 2003-2006 in Europe are the following: (i) promoting
economic growth, (ii) creating jobs, and (iii) sustainability of public finances.
•
Economic growth in Europe has fallen behind its potential in the past three years. This again
seems to point to the need for structural reforms. It is in the interest of Estonia that structural
reforms targeted at improved efficiency in the use of resources would continue both in the
recently joined countries as well as in the old EU member states.
•
Regardless of the fears prevalent in the 'old' Europe, extensive labour influx from the new
member states in the near future is unlikely. Therefore, the insufficient flexibility of the
pan-European labour market has to be counterbalanced by as efficient as possible internal
market, high mobility of capital, and as flexible as possible internal labour market.
• Estonia is building up a modern pension and health insurance system. This is an area where
also the current 'old' member states will probably have to focus more on individualised
contributions and securing more extensive employment.
• Yet the greatest problem the European Union faces is the due to the need to
budget issue
reform the pension system and in particular the healthcare system in the light of long-term
sustainability and on account of the budgetary positions of the member states that
deteriorated in 2003. The excessive budget deficit procedure was initiated against Germany
and France which exceeded the maximum budget deficit allowed according to the Growth
and Stability Pact, 3% of the GDP - and the number of such member states will probably
grow. At the same time, the situation initiated a discussion regarding sufficient flexibility of
the Growth and Stability Pact, first and foremost in the context of a weaker economic
situation.
•
Estonia's budgetary policy is and has been strict and balance-oriented. This gives us a
competitive advantage over others and does not place us in an inferior position, contrary to
what has been erroneously claimed. The current debt burden of the Estonian government
sector is about 5% of the GDP (the lowest in the EU accession countries); the budget deficit
of the government sector rose above the maximum level allowed under the Maastricht
criteria only in 1999.
•
While assessing the relevance of the budgetary balance requirement from the viewpoint of
Estonia's future competitive ability, one certainly has to bear in mind that merely meeting the
budget criterion might not be a sufficient success guarantee. In the conditions of the
common monetary policy, the budgetary policy will become the principal economic policy tool
through which the government can independently influence economic development (e.g.
stimulate its economy in the period of slow growth). But in order to actually use such
budgetary policy tools flexibly, the budget has to be balanced not in the course of just one
year but across the whole economic cycle - posting a surplus in the periods of fast economic
growth while showing not a very large deficit, a maximum of 3% of the GDP, in the period of
downturn.
There has been a notion spreading among Estonians that we are extremely good... Hence the
biggest threat facing us is complacency.
• Besides its significant role in the world trade, the European Union has long been a net
investor in the rest of the world. But the level of investments within the European Union, at
least in the old member states, remains lower than it could and should be. A well-considered
investment policy is one of the key issues from the point of view of European economic
development prospects. Creating an attractive investment environment and utilising the
know-how accompanying the investments is an area where Estonia has (at least in the case
of the financial sector) successful experience to offer to Europe. At the same time, Estonia
as an EU member state should learn from the experiences of other states.
•
In 2004-2006 an average of 2.7 billion kroons per year is flowing into Estonia from the
European Union. According to the present financial estimates, the inflowing amount will be
around 40 billion kroons in 2007-2013, an average of 5.6 billion kroons a year. At the
moment we have managed to make use only over half of these funds. It is quite another
matter HOW to use the inflowing money IN A SENSIBLE WAY.
• Estonia hopes to be successful in Europe like many other small countries,
e.g. Finland and Ireland. However, this does not mean that copying the solutions and
development approaches of these countries would necessarily guarantee success. For
example, it would undoubtedly be of great use to learn about the experience of Finland's
SITRA, Ireland's Forfas and ICSTI, and other similar state-owned structures designed to
promote modern knowledge, product development, and manufacturing. But Estonia has to
face the fact that the majority of the projects successfully launched with SITRA's co-financing
are related to innovations that have received an additional quality guarantee - a patent or a
useful model certificate - considered essential by venture capital investors. According to the
Estonian Patent Office, considering the number of globally innovative products per 100,000
inhabitants and the products' patents, Estonia is lagging behind the EU member states up to
50 times - in Finland an average of 40-50 patent applications per 100,000 inhabitants are
submitted per annum; in Ireland the respective figure is 30, and in Estonia less than one.
Naturally, this is just a single indicator among many others and other factors should be taken
into account, but still...
• Maybe this is where we should start? It is quite obvious that Estonians have no other way of
achieving success than using their knowledge and skills. As we all know very well, Estonia
does not have oil fields at the expense of which we could become rich. Innovation and
willingness to develop should become a pervasive way of thinking for us, there should be a
change in our values.
•
The world economy is currently going through changes in its fundamental paradigm and
turning into a knowledge- and innovation-based economy, founded on creating, introducing,
and applying knowledge. And the focus is on the latter, application of knowledge,
i.e. innovation.
• Innovation can be defined as a novel and successful application of knowledge and
technology in order to achieve a competitive advantage. The competitiveness of companies
in knowledge-based free market economy essentially narrows down to their innovation, i.e.
their ability to find and sustain their originality and thus a market position enabling high
returns. It is international competition between companies that ultimately creates an
opportunity for economic growth and thus for the increase in the society's welfare.
•
Innovation requires at least three factors: firstly, educated and competent people; secondly,
a well-functioning financial system covering the whole chain of innovation; and thirdly, a
culture favouring innovation and entrepreneurship.
•
Is Estonian labour really competitive? Do we want to be price or quality leaders? If the
goal is to be price leaders, our salaries should be as low as possible. If we want to be quality
leaders, the situation is vice versa. In order to generate innovation, innovative people have to
be raised in Estonia, brought to Estonia - and kept in Estonia, hence the aim should be to
create more high-productivity jobs.
•
I maintain that being a part of Europe, we should become quality leaders since we have
already lost the price leader position to Asia. This is undoubtedly easier to say than to do.
Here we face the threat of outpacing the so-called natural development, which calls for
step-by-step industrial development towards manufacturing products with increased added
value - such a development is in fact currently under way in Estonia. On the other hand, the
payback period of such investments is very long and the experience of several countries
(including Finland and Ireland) has shown that success often arrives only decades later.
Consequently - if it is our goal to become a quality leader, development activities in
this direction should be launched as soon as possible.
•
Here we come to the question, WHERE to start? The answer requires a good prediction or
even a vision: which areas have enough potential in Estonia that are worth to be given
systematic development priority. It is possible that due to its small size Estonia lacks any
potential for developing high-technology industry since this would require the emergence of
clusters. Even if we manage to develop our own high-technology industry, sufficiently
high-level know-how will most likely emerge only in few fields. However, this does not mean
that we should develop just a few areas. According to the principle of risk-spreading, it would
still be better to support research and development activities on quite a broad basis.
•
The economic analyses by the central bank consistently emphasise that in order to obtain
financial capital required for development, Estonia must remain attractive in the eyes of
foreign investors al