Vahur Kraft: Challenges facing Estonian economy in the European Union
Speech by Mr Vahur Kraft, Governor of the Bank of Estonia, at the Roundtable "Has social market
economy a future?", organised by the Konrad Adenauer Foundation, Tallinn, 19 August 2002.
* * *
A. Introduction, review of the early 1990s and comparison with the present
day
First of all, allow me to thank Konrad Adenauer Foundation for the organisation of this interesting
roundtable and for the honourable invitation to speak about "Challenges of Estonian economy in the
European Union". Today's event shows yet again how serious is the respected organisers' interest
towards the EU applicant countries.
I personally appreciate highly your support to our reforms and convergence in the society and
economy. From the outside it may seem that the transformation and convergence process in Estonia
has been easy and smooth, but against this background there still exist numerous hidden problems.
One should not forget that for two generations half of Europe was deprived of civil society, private
ownership, market economy. This is 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. They are of
different kind. If people want the state to ensure their well-being but are reluctant to take themselves
any responsibility for their own future, it is the 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 is the state's role, it is the shadow of the past.
But, of course, in ten years a lot has been achieved. We have built up democratic institutions. Market
economy functions. Private ownership has a solid foundation. Banks provide credit to people for new
housing developments. But our current success should not be taken for granted. And we should also
bear in mind that much needs to be done yet. The public has to understand the role and possibilities of
the state and the government in the market economy. Everybody should feel responsible 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 the modern society much better than we did.
In our efforts to achieve this goal it is impossible to underestimate the support provided by our
partners. The Estonian society and politicians need partners with whom to exchange experience and
from whom still to learn the fundamentals of the functioning civil society. At that, I would like to thank
Konrad Adenauer Foundation for the work it has done and is doing in Estonia and elsewhere for the
promotion of political co-operation, preservation and support of free democracies throughout the world,
development and consolidation of the social market economy and respective values.
Allow me to express in my address also full recognition to Prime Minister Mart Laar who has been the
leader of the Estonian government during several critical periods. Mart Laar was the head of the
Estonian government during one of the most difficult periods - from the autumn of 1992 to November
1994. This was the turbulent period of initial reforms not only in the economy but the entire society,
immediately after the monetary reform and adoption of the constitution. But, with your kind consent, I
shall hereby focus on economic issues.
These were the times when Estonia's foreign reserves, in the current denomination, could have been
expressed in hundreds millions of euros, the average monthly wage was slightly above one thousand
kroons and, by the end of 1992, three big banks had collapsed. These were the years just after the
monetary reform when the question "for how long this kroon is 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 stressed that the foundation for our relative economic
success was laid in 1992 and 1993. Our banks would not be so strong to date without solid customers
- private enterprises, 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 sound and strong
customer base. Due to that Estonian banks have been able to extend credit to the strong private
sector, in particular. Thus we managed to avoid the situation that many former socialist economies
were forced to experience - floating of problem loans directly or indirectly to state-controlled, 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 1990s. Neither did the government
hesitate when it was necessary to liquidate badly-managed, insolvent enterprises that were
manufacturing for stock. Privatisation of state-owned companies for real money to core investors, and,
if necessary, 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 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 perspective-lacking 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 means
and how the amount of state-collected taxes and public expenditure 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 put at stake. The 1992-1993 strictly balance-oriented strategy helped to
create the social foundation that would even to date be suitable for developing a fiscal policy capable
of even better supporting the balanced economy.
I touched upon the economic policy key issues of the past decade because the same issues that were
topical then are on today's and tomorrow's agendas. How to achieve better economic efficiency and
improve competitiveness? How to avoid the deterrent impact of local lobby-groups on the economic
policy and ensure a truly effective and free market? How to develop a truly balanced and
forwardlooking fiscal policy? These issues are in the focus not only in Estonia but also in the European Union.
Naturally, today's problems - like the society itself - have a completely different look than 10 years ago.
It is not only Estonia that has changed, it is the entire world. However, the key questions - likewise the
optimum solutions to them - are, in essence, the same.
I would like to offer just a few examples for the illustration of the above-said. In the beginning of 1990s
we created in Estonia conditions for truly free competition in the financial sector and the entire
economy. Estonia abandoned all possible barriers to import and export of goods and services, created
equal opportunities to all investors and privatised state-owned banks. These steps laid the foundation
for our current success. To date, 10 years later, Estonia like the European Union discusses widely
how to create a truly free market of infrastructure services which until now have been either directly or
indirectly protected by the state. And principal solutions to this problem shall not differ from the
decisions made in the first half of 1990s.
It is true that, for example, opening up of the electricity market to free competition is definitely more
time-consuming than privatisation of many industrial enterprises. But, surely, restructuring of the
electricity sector does not differ in principle from the reform in 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 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. And when these guidelines and relevant national policies
are in place, there will be no 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 speed it up. I am positive that, like
in the banking sector, the society will benefit from this. It will result in more efficient production, lower
prices, better service quality and curb the power of the monopolistic producers.
To date, 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. But, in essence, it is the same question - what
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 economic policy key 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, others have remained unresolved.
One thing is clear - undue postponement of tough issues is no good to anybody. If we want to be
treated as equal partners in the European Union, if we want to sustain the rapid growth rate and
growing income level, we must tackle these problems with similar resolution and energy we did
10 years ago.
B. Challenges facing Estonian economy on its way to the European Union
- internal policy
So - what are today's and tomorrow's challenges facing Estonian economy? Filled with pride for 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 opening
opportunities. What should we then focus on especially?
B.1 Challenges facing Estonian economy on its way to the European Union - overall
economic policy stance
Estonian economy is already strongly integrated into the European economic area. From the
perspective of the central bank I would like to refer to the clear convergence of the interest rate
fluctuations and inflation cycles in Estonia and the European Union.
The share of current and future EU member states in Estonia's export is about 81%. In 1994-2001
Estonia's export to the European Union increased on the average 25% per annum. Our exports to the
European Union have steadily grown quicker than imports from the European Union. It means that we
have been steadily increasing our market share in the European Union - although it is small. The
export structure also characterises our competitiveness - exported goods reflect changes that have
taken place in the economy. Our traditional export items are timber, textile and foodstuffs, but also, for
example, parts and components of electric motors, cables, mobile phones, antennae and the like. We
export not only goods but also services - primarily transport and travel services - also computer and IT
services and the volume of these services has been increasing rapidly during the last three years.
The FDI inflow that has reached the 9 billion kroon level in recent years proves our competitive
position in the Baltic Sea region as well as a broader region. Equal distribution of investments between
the main sectors of economy is an indication of the balanced 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 the FDI inflow was not contingent on the privatisation of
former SOEs. And finally, our competitiveness is demonstrated by the yield of investments made in
Estonia and reinvesting of substantial part of annual profits which in 2001 amounted to 3,8 billion
kroons. This is also shows our competitiveness.
The readiness of Estonian economy for the 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 of the market to domestic and
foreign competition, strong state supervision and integration of Estonian enterprises in the big
multinational corporations.
What should we focus on in the future?
Estonia is no longer a catching-up candidate country as it was three-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 the
membership. What should we focus most on?
First, a clear vision of the state's role in the organisation of the economic system. The task of the state
is not to produce goods or services - be it in such specific areas as energy or rail transport. The task of
the state is to ensure the functioning of the market wherever it for some or other reason requires its
support.
Secondly, unemployment has become a problem in Estonia. Without dwelling on concrete statistics, I
would like to emphasise that labour market is subject to the same set of rules as all other markets. If
labour is too expensive, 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 we should in Estonia seriously and comprehensively
analyse factors that influence employment, including absolute or relative taxation of the workforce and
costs related to hiring and layoffs.
Thirdly, the balanced growth. Reforms are not an objective per se, we undertake them with the
assumption that they will lead to a higher economic growth rate, higher income and 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 to 5721 kroons. During the
same time 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 the 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 - 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, changes in the productivity and
competitiveness. It is obvious that no country, not even Estonia, when planning its economic policies
should assume, for example, a 8-8% current account deficit spanning several years. Even if the latter
is in the initial years financed through foreign direct investments, the adaptation of the economy is
inevitable. The slower the economic growth is during the adaptation period, the more painful it is for
the society. The goal of the economic policy should be the prevention of the internal demand-driven
boom immediately prior and after the EU accession which will 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 stress that the
projections which form the basis of the national pre-accession programme and the premise that in
Estonian economy the real total output is going to increase at the rate of about 6% per year are
attainable only if the current economic policy continues. Keeping of the 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 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 - on the other hand, one can say that only these economies that meet the
requirements can benefit from the transition to the single currency. And Estonia's monetary and
exchange rate policy during the pre-accession period and immediately after the EU accession should
be considered against this background.
First, 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 condition of the Estonian economy and financial system as well as integration with the EU
markets that I commented upon earlier in our view fully support this principle.
Also the European Commission and the European Central Bank have affirmed 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, ERM2 provides to 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
new member states has been diverse. ERM2 is a suitable and flexible means for the harmonisation of
varied monetary policies and applied tools.
The post-accession period will most likely be a serious test phase to most member states - definitely
Estonia - in elaboration of their economic and fiscal policies and relevant co-operation with the 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 will have joining in the EU processes whereas the
"old" member states will have to study the key problems the new members states face in their
economic development. The post-accession ERM2 phase is an appropriate time for the establishment
of the comprehensive co-operation 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 the exchange
rates but interest rates.
Maastricht criteria
For Estonia like for all new member states the only possible way to join the euro system is to do it in
full compliance with the letter and spirit of the EU Treaty. As we well know, the key issue here is the
fulfilment of the Maastricht criteria. Most new member states, Estonia included, 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 achievable in
not so distant future. However, in the context of rapid accession, the meeting of the inflation criteria
becomes a main issue. This is due to the interaction of the so-called real and nominal convergence.
Together with the rapid growth of productivity and earnings, prices are going to rise quicker in the new
member states. Considering great price gaps in applicant countries v?s a v?s 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 for several years stay higher than the mean rate of the three lowest inflation
economies in the European Union plus 1.5 per cent. We have estimated that for Estonia the "optimum"
pace for streamlining of prices would be ca 2 to 3 per cent points per year. In our opinion this
difference reflects the quicker productivity increase trend in Estonia.
In conclusion, 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-operation modes has been raised
repeatedly, This is also discussed at the Convention on the Future of Europe. Figuratively speaking,
the question means which policy measures foster the best utilisation of the possibilities offered by the
single currency.
C. Challenges facing Estonian economy on its way to the European Union
- the EU perspective
The first priority issue is naturally the further improvement of the EU internal market. The on-going
convergence and improved operational efficiency of the internal market will make prices more flexible
and allow better use of resources. It is extremely important to develop the common market for all
goods and services, including telecommunication services and other utilities - also financial services in
order to ensure free competition and price formation based on the demand and supply on the
Pan-European market. A well-functioning common market should help to reduce transaction costs, by
offering more and more services via the internet, for example. A common innovation policy, system of
business support measures and dissemination of experience of different businesses, availability of
start-up capital - all this is deemed to promote productivity and further convergence.
Flexibility and mobility of production factors
Another set of critical issues is related to 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 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 would be easier if business laws and regulations of different countries are harmonised. Here I
could mention rules governing companies' mergers and takeovers, bankruptcy procedures, state aid
distribution terms and conditions.
A flexible labour market is extremely important for the effective common monetary policy purposes.
However, it is unlikely that in the near future Europe will see any notable crossborder migration of the
labour force - it is not expected to happen before or after the EU enlargement. Therefore, 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 to mitigate 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 wealthy to the less-wealthy
regions - thus, in fact, compensating for the lack of the exchange rate mechanism within the single
currency regime. Also 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 sufficiently many examples of great disparities
between different regions of a federal state. Regional policy is crucial also for states with high labour
mobility. Ultimately, the success of regional economies depends primarily on the efficient resource
management and extensive income transfers can even slow down the adjustment process.
In my view it is obvious that as long as the European Union remains to be the alliance of independent
member states, there will be neither need nor possibility for any additional communitisation.
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. Harmonisation of the
fiscal policy on the macro level would be automatically accompanied with the tax rate equalisation. At
that, taxation policies of any given member state reflect principal choices of their internal policy and
preferences of the entire society.
Stability and growth pact
With the regard to the Stability and Growth Pact, it is assumed that automatic stabilisation
mechanisms shall function smoothly within the 3% GDP scale. This threshold could be exceeded only
in case of an abrupt or unexpected shock situation. Additionally, the Stability and Growth Pact aims at
a balanced budget during 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 remain a cornerstone of the EU economic policy also in the years to come.
Further convergence of markets and various national economies should by itself prop 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. And even more importantly, harmonised and flexible commodity markets will help to
reduce adjustment costs - and thus minimise 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
the recent past. Estonia as the 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
to other European states, be able and willing to participate in the discussions on the monetary and
fiscal policy issues, 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 potentials of the single
currency will be exploited in the best possible way. It would serve the interests of the current as well as
future member states and the whole of Europe.