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Estonian economy

Contents:

Preconditions for Transforming the Economy

For the Baltic states, their geographical position between Scandinavian countries and Russia has been an important determinant of economic, political, social, cultural etc. development. In good times this has meant large trade flows and accumulation of wealth, in bad times political dependence. The earlier experience of independent statehood from the period between the two world wars was common for the Baltic states, and it is one of the main differences compared to other former republics of the Soviet Union. This historical experience has been very important for the creation of institutions necessary for a properly functioning state. 

In the case of Estonia, being neighbour to Finland has been vital. The closeness of Estonian and Finnish languages was important especially during the first years of independence. Considering more general issues from the point of view of market economy, a relatively good idea of what market economy is en masse and what the main rules of democratic society are has spread via TV and other communication channels. This partly compensated for the iron curtain, even more tightly closed compared to several Central European countries such as Hungary or Poland during the communist period, and made possible an exchange of information. The close economic connection played an important role in the transformation of foreign trade from East to West and supported the later integration with the Western world and particularly with the EU. 

Local natural resources, of which oil shale is of the greatest importance, has substantially influenced the structure and dynamics of Estonian economy. Already in the 1920s, the mining of oil shale started for the production of oil for burning in different equipment and for the chemical industry. After the Second World War, the oil shale-based power engineering industry was created. This industry produced the dominating part of electricity in Estonia also in the 1990s. 

In 1970s and 1980s, the Baltic states had typical features of industrial countries. The most important characteristics were a much larger proportion of manufacturing and agriculture than in developing countries and a modest state of infrastructure, service and trade sectors in the economy. The transition to market economy has been accompanied by the introduction of modern banking and finance, markets for real estate and business services. Retail and wholesale trade also grew rapidly. 

In the 1980s substantial investments were made into transportation. The most significant project was the Muuga port near Tallinn. After independence was regained, that port has been increasingly vital for Estonian economy in serving domestic needs and transit trade. 

Monetary Reform as an Important Determinant of Change

Although the restoration of Estonia's independence in August 1991 brought with it several changes in the institutional framework of economy, Estonia still remained in the rouble zone. A major price increase took place in the first months of 1992 because the prices of raw materials were increased in Russia at the beginning of the same year. The prices of fuels and other resources shot up. As Estonia imported the bulk of its inputs for industry from Russia, this brought along a forced liberalisation of most of the prices which were still regulated, and a sharp price jump in Estonia (in 1992 inflation was 1076%). When Estonia started to introduce its own currency in June 1992, prices subject to the control of the central or local governments were limited to oil shale, electricity, transportation, rental tariffs, heating costs, and postal and telecommunications services. 

The monetary reform conducted in June 1992 was a major turning point in economic reforms. As the list of articles written on the details of the Estonian economic reform is rather long, here only some of its more general features are described. The establishment of a currency board and the convertibility of the Estonian kroon were introduced. The exchange rate of the kroon was fixed to the DEM (1 DEM = 8 EEK), with the exchange rates with other currencies calculated according to the rate to the DEM. Both private individuals and enterprises can convert the kroon into foreign currency without restrictions. 

At the introduction of the exchange rate of the kroon, the rate of the foreign exchange auctions was used with the result that the kroon became by some estimation even 7-8 times cheaper than the purchasing power parity (PPP) rate. This made Estonia's import expensive, favoured the export of goods and services and provided the exchange rate of the kroon with a reserve against inflation in the domestic market. 

The fixed exchange rate of 1 DEM = 8 EEK, introduced in June 1992, was still at the same level in April 2000. At the same time, Estonia had a relatively high level of inflation also after the monetary reform. Estonian economic development under a fixed exchange rate arrangement has resulted in constant appreciation of the price of domestic inputs. On the other hand, despite the increasing costs of production, Estonian enterprises have remained competitive and the economy has witnessed rapid growth of output and exports. 

That growth is first and foremost related to institutional and structural changes. Institutional changes (free trade agreements with other countries, trade relations with new foreign trade partners, improved quality control that made the production acceptable in foreign markets, etc.) ensured access to new markets. Structural changes - the establishment of new companies producing high-quality goods and in the adaptation of existing companies-facilitated the marketing of goods and services despite the increased domestic production costs. 

The Currency Board Arrangement

The currency board arrangement leaves rather small space for choice of economic policy. From the very beginning of the reform, the flows of goods and services, but also of money and capital were liberalized. One reason for an open economy is the small size of the domestic market (Estonian population is 1.5 million). The economic decline and the low purchasing power of the population had forced Estonian enterprises to export a large share of their production. 

The following scenario describes the relation of macroeconomic conditions to economic growth. The undervalued kroon, as measured by the purchasing power parity, contributes to lower production costs and stimulates foreign investment. The low cost of production factors, along with foreign direct investment in the form of technology and know-how, will in turn increase exports, which become the source of economic growth. The pegging of the Estonian kroon to the German mark (starting from 1 January 1999 to Euro) would guarantee the credibility of the currency and the overall stability of the economic environment. 

If this scenario is combined with high inflation, however, nominal price increases in production factors will be translated into an increase in production costs and purchasing power in international terms. Thus, if a fixed exchange rate arrangement is accompanied by inflation greater than that of the country's trade partner, the real exchange rate will appreciate, which hampers exports, increases imports, aggravates the foreign trade deficit and might lead to a balance-of-payments crisis. 

In the case of Estonia, the real exchange rate of kroon appreciated, on the average, three times (five times with respect to currencies of industrial countries) in 1992-1999. Since 1 January 1997 until 1 January 2000, the 20% appreciation of real effective exchange rate of the kroon occurred. In 1993-98, imports increased 13.2 times, while exports increased 8.4 times. Due to Russian financial crises, Estonian export and imports declined in 1999, but started rapidly growing during the first months of 2000. In 1999, exports totalled 43.2 billion kroons while imports stood at 60.5 billion kroons, yielding a trade deficit of 17.3 billion kroons. The foreign trade deficit was offset by surpluses in services and capital account. The current account deficit increased to 12.1% of the GDP in 1997, but declined to 9.3% in 1998 and to 6.3% in 1999. 

Changes in the Economic Structure

It has been characteristic of Estonian economic reform that no branch of economy has been preferred; practically the only determining factor in the restructuring has been the ability of an enterprise to adapt itself to economic conditions, especially its ability to orientate itself to the Western market. This situation has been caused by the indeterminacy of the economic situation, the sharply changing proportions of prices, and the rapid contraction of the eastern market. 

The most direct consequence of the changed economic environment has been the sharp decline in production in all branches of economy. Economic changes were very much influenced by the prices and foreign economic shock. The cumulative decline of the GDP during the period 1990-1994 was 36%. 

Economic growth has been evident since 1995. The GDP increased in 1995 4.3% and in 1996 3.9%. The industrial output increased respectively 2.0% and 3.5%. During1997 the growth speeded up. In 1997, the GDP increased 10.6% and in 1998 4.0% . The Russian financial crises had an effect on industries whose main export target was Russia (food industry). In 1999, the GDP declined by 1.1%, but started growing again in 2000. Due to significant changes in foreign trade and economic relationship from east to west during the 1990s, the effect of the financial crises in Russia had a relatively moderate influence on Estonian economy. 

In 1997, the industrial output increased by 15.2% and in 1998 by 3.2%. The decline of 3.8% followed in 1999, but the growth recovered again in 2000. The economic indicators of the Estonian economy are presented in Table 1.

Estonia is overcoming the economic crisis with a notably changed economic structure. The shares of trade, transportation and the service sector have increased rapidly. The share of manufacturing was 35.1% and that of agriculture (together with hunting and forestry) 22.0% in the GDP in 1989. In 1996 the share of agriculture was 5.2% and in 1998 3.8%. The share of manufacturing decreased to 14.8% in 1996 and 13.7% in 1998. At the same time, the share of trade in the GDP increased from 7.0% in 1989 to 15.3% in 1996 and to 16.2% in 1998; the share of transportation and communications from 6.9% to 9.7% and 12.2%. The share of financial institutions and insurance captured 4.2% in 1996 and 3.5% in 1998, the real estate, renting and business services respectively 8.6% and 9.6%. The structure of the Estonian GDP has become rather close to that of the GDP of developed countries. As these structural changes are the result of deep economic decline and foreign trade shock (rapid change of terms of trade, deep decline of trade with Russia), which was most complicated for industrial enterprises, one very important question is what the share of traditional branches like manufacturing and agriculture will be after a revival of these branches.

Foreign investment could be one of the solutions to the structural problems cited above. The total amount of foreign direct investments (FDI) into Estonia, which according to the Bank of Estonia was 38.0 billion kroons on 31 December 1999, places Estonia in a satisfactory position among other Eastern European countries. Sweden with 41% and Finland with 30% were the most important countries from where the FDI came. Transport and communication with 27%, financial intermediation with 24% and manufacturing with 23% were the most important branches for the FDI. 

Foreign Trade

As Estonia has had the same fixed exchange rate since 1992, the increase in foreign trade occurred also in convertible currency terms (US$ or DM). The growth of exports during the time the currency appreciated, seems to be at first glance paradoxical. However, here the initial conditions of economy and the general framework of development should be taken into account. Estonia started its reorientation towards Western markets when a very large share of its production was unacceptable to the markets of developed countries; Estonian enterprises had to substantially change the character of their products. Numerous enterprises changed from being producers of manufactured and semimanufactured products to being subcontractors of Western firms. Several raw materials (unprocessed wood, scrap metals) formed a considerable share of Estonian exports. 

The structure of Estonian imports has been largely determined by the necessity to purchase fuel and other raw materials (e.g. cotton as an important input for Estonia's rather large-scale textile industry). Machinery, mechanical appliances and electrical equipment have also been important imports. Shortly after the monetary reform, the purchasing power of Estonian economic agents was artificially set very low. Domestic inflation and an increase in real incomes since 1995 increased the demand for imported goods. Evidence of this was the increasing value of imported consumer goods, which also contributed to the growth of the foreign trade deficit. It was only in 1999 that, due to the continuing impact of the Russian financial crisis and lower domestic demand, the foreign trade balance improved. The recovery in economic growth is expected to put new pressure on that balance, though the export potential of the country has improved in recent years, to a large extent due to foreign direct investments.

The geographical pattern of foreign trade by regions is described in Table 3. EFTA countries dominated Estonian foreign trade until 1994. As Estonia's main trading partners, Finland and Sweden, and also Austria, joined the EU from 1 January 1995, the EU's share was the highest in 1995 and also afterwards. In 1999, 62.9% of Estonian exports went to the EU, and 57.7% of imports came from that region. The share of the CIS was respectively 13.4 and 17.0%. 

The geographical pattern of Estonian foreign trade changed substantially in 1992. Reorientation to the Western market was not easy, and most producers were not ready for it. Finland played an essential role, encouraged by its knowledge of these markets and the linguistic similarity. Finland's market share in 1991 was 2.3% of Estonian exports and 2.0% of its imports, increasing to 21.2 % and 22.6 % respectively in 1992. During the next few years, Finland's share remained rather close to these figures: in 1998, Finland accounted for 18.7 % and, in 1999, for 19.4 % of Estonian exports and for 22.6 % and 22.8 % respectively of imports. Finland also acted as a mediator for Estonian entrepreneurs. One reason why Finland's share is high in Estonian foreign trade is the large number of direct foreign investments from Finland in Estonia: the enterprises created on the basis of those investments tend to trade with Finland. 

In the commodity structure of exports, traditional articles such as textile and food products have declined in relative and absolute terms, and in 1999, machinery and equipment had the largest share with 20.9% in Estonian exports. The export of electrical devices was 79 %, and machinery and mechanical devices accounted for 21 %. The share of radiotelephones and components of TV sets in the export of electrical goods was about one third, with the most important markets in Sweden and Finland. The share of mobile phones in that commodity group was about 25 % (mainly subcontracting to Sweden). Goods produced by subcontracting accounted for 73 % of the exports of electrical goods. 

In 1999, wood and articles of wood accounted for 14.5% of exports. The share of round timber was 35% and of sawn timber 29% of that commodity group. The major markets for round timber were Sweden, Finland and Norway, and for sawn timber, the UK and Germany. Other items in this section were chip and fiberboards, plywood and construction details and furniture. 

Textiles and textile articles accounted for 11.8% of exports in 1999. Major items were non-woven clothing, with 39%, cotton products, with 19% and hosiery products, with 15%. The main markets were Finland and Sweden, which also were the major customers of subcontracting. 

A very rapid increase of exports of food products to the CIS market occurred in 1997 and during the first half of 1998. Processed foodstuffs made up 8.2% and animal products 6.2% of exports in 1998. Dairy products made up 39% of the export of animal products. The main item of export was milk powder, accounting for 40% of the export of dairy products. For certain items, Estonian producers and traders are interested in having economic ties with Russia. As Estonia does not have a More Favored Nations (MFN) agreement with Russia, Estonian exports suffered from higher customs. The Russian financial crisis put an end to the boom in the Estonian food industry and forced another restructuring toward a lower share of traditional manufacturing industries. 

The shares of capital and know-how intensive industries have increased in Estonia's exports, but there is still a relatively high proportion of natural resource and unskilled labour intensive industries such as the manufacture of wood and textiles. 

Machinery and equipment was the most important single article with 27.0% of total imports in 1999. More than one-third of those products were imported for processing. Base metals and metal products accounted for 9.7% and chemicals for 9.3% of imports in 1999. 

In the category of textiles and textile articles (altogether 7.8% of imports), cotton accounted for a quarter (the main suppliers were Uzbekistan, Tajikistan and Turkmenia), and clothing contributed 17% (the main supplier was Finland). 

Mineral products accounted for 7.4% of imports (95% of them consisted of fuels, of which two-thirds were light and heavy oil and one-third gas). The main suppliers of oil were Finland (re-export) and Russia, and the main supplier of gas was Russia. 

Trade with the other Baltic countries, Latvia and Lithuania, has been rather modest. In 1999, Latvia's share in Estonian exports was 8.7% and in imports 2.2%. To Latvia, Estonia exports electricity, which was the largest single article in 1992 and 1993. Later the share of electricity fell, and chemicals became the leading items. Lithuania's share was 4.7% of exports and 1.6% of imports. Mineral products made up 38.7% of Estonian imports from Lithuania in 1994, but only a fraction of that in 1999. Estonia's exports to Lithuania were dominated by food products (16%), machinery and mechanical appliances (13%) and chemicals (12%). 

Estonia, Latvia and Lithuania signed the Baltic Free Trade Agreement in 1992 (enforced in April 1994). Additionally, since 1997 a free trade agreement on agricultural products has been in force. Nevertheless, the trade volumes between the Baltic states have been quite modest. One reason could be that all countries are exporters of quite similar raw material and cheap labour intensive products and advantages of intra-industry trade have been not realised. 

Germany has also been a market for wood, furniture and textile products (these items comprised 22%, 21% and 16% of Estonian exports to Germany in 1999). Estonia imported from Germany mainly transport vehicles (27% of imports from Germany), machinery and mechanical appliances (25%) and chemicals (9%). Historically, between the two World Wars, Germany was the main trading partner of the Republic of Estonia. 

From transition to EU integration

The significant changes have also created conditions for co-operation and integration of Estonia with the EU. First assistance was granted under the PHARE program. The next step for deeper integration was taken with the Free Trade Agreements (FTA). The FTA between Estonia and the EU came into force on 1 January 1995. Estonia negotiated the Europe Agreement (Association Agreement) in 1994-1995. The European Agreement (EA) with the European Union was signed on 14 June 1995. Estonia is the first country to conclude such an agreement without a transition period. The Europe Agreement is partly based on the FTA between Estonia and the EU. The EA replaced the FTA after its ratification in February 1998. The FTA became then part of the EA. 

Estonia presented its application for membership of the European Union on 24 November 1995. The European Commission presented an opinion on the application and recommended to commence accession negotiations with Estonia. At the Luxembourg Summit in late 1997, the European Council decided to begin EU accession negotiations with six countries, including Estonia. The Intergovernmental Conference in Brussels in March 1998 marked the beginning of Estonia's accession with the EU and the formal accession process. 

Special standards, quality requirements and other regulations, as well as differences in legislation and complicated administrative procedures can be important trade barriers to market access. One way to remove trade barriers is to harmonise regulatory regimes (e.g. standards, administrative requirements, customs procedures, product testing, certification etc.). Therefore, an approximation to the EU quality standards is one of the main objectives of Estonian pre-accession phase. Implementation of the rules, standards and norms of the Single Market will help to increase the competitiveness of Estonian companies by removal of the cost-creating barriers and, thus, improving the market access. The final objective of Estonia is to harmonise all the legislation with the acquis communautaire in all relevant areas. 

In March 1998, the accession negotiations between Estonia and the EU were launched. During 1998 and 1999, the so-called 'screening' exercise took place, which was finished in autumn 1999. The acquis communautaire, the body of all the EU rules, is divided into 32 chapters, and under each chapter the Estonian legislation and administrative system was carefully analysed. The aim was to find out how much Estonian legislation has already been harmonised with the EU rules and which steps must still to be taken. The current aim is to harmonise the major part of Estonian legislation with the EU system by the end of 2002. In several areas, the need for a transition period is envisaged. 

Estonian integration into the world economy has been promoted by a liberal economic policy and several agreements signed on the state level. Participation in organizations promoting trade cooperation (a free trade and association agreement with the EU, with other Baltic states, and the EFTA countries) have accumulated benefits for Estonia which could not be pursued from partnership with separate countries. 

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This fact sheet is published by the Estonian Institute in May 2000 and is intended to be used for reference purposes. It may be freely used in preparing articles, speeches, broadcasts, etc. No acknowledgement is necessary.