Estonian economy

Preconditions for Transforming the Economy

The Estonian economy had the features of a typical industrialised country in the 1970s and 1980s. A significant difference from the economy of the developed countries was the modest state of the infrastructure of production, services and trade. In the 1980s, major investments were made to serve transportation connected with Soviet foreign trade. The largest site was the Muuga port near Tallinn. Initially it was planned for operation as a port for grain and container conveyance to serve the foreign trade of the Soviet Union via the Baltic Sea. Since the time Estonia regained independence, the port has become an increasingly important link in the structure of the Estonian economy. Estonia also has its power engineering complex based on oil-shale with the two largest plants near Narva built in the 1960s and 1970s.

The economy was characteristically quite open in that period. An estimate made in the early 1990s, found exports accounted for 50.8 and imports, 62.0% of the GDP in 1989. Trading was mainly orientated toward other regions of the Soviet Union. Their share of Estonian exports in 1989 was 94% and of imports, 82%. So the structure of the economy and foreign trade was overwhelmingly a result of the realisation of the plans of various all-Union ministries.

As with the other countries of the socialist system, the Estonian economy was characterised by a structure of relative prices significantly different from those in the developed countries; a large part of investments were funded by redistribution of funds within the state budget; the exchange rate of the rouble did not correspond to actual price ratios; a great share of foreign trade was organised in a framework of barter transactions.

Monetary Reform as an Important Determinant of Change

Although restoration of Estonia’s independence in August 1991 brought with it several changes in the institutional framework of the 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 went up several times. As Estonia imported the bulk of its inputs for industry from Russia, this brought a forced liberalisation of most of the prices which were still regulated and a high price jump in Estonia (from December 1991 to December 1992 inflation was 952%). 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 reform. 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 restriction.

Upon 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 estimations 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 DEM 1=EEK 8, introduced in June 1992, remained at the same level at the end of 1997. At the same time, Estonia had a considerable level of inflation after monetary reform. Inflation was 89.8% (here it should be remembered that for the whole of 1992 inflation was 952%) from June 1992 until December 1992; 35.7% in 1993; 41.7% in 1994, 28.9% in 1995 and 14.8% in 1996.

The Currency Board Arrangement

The currency board arrangement leaves rather small margins for possible choices of economic policy. From the very beginning of the reform, the flows of goods and services but also of money and capital were liberalised. One reason for an open economy is the small size of the domestic market (Estonia’s 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 direct foreign 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 should 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 5-6 times greater than that of the country’s trade partner, the real exchange rate will appreciate, which hampers exports, increases imports, worsens 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 average, three times (five times with respect to currencies of industrial countries) in 1992-96. In 1993-96, imports increased 7.6 times (32.5% in 1996), while exports increased only 4.6 times (18.8% in 1996). In 1996 exports totalled 25 billion kroons while imports stood at 38.6 billion kroons, yielding a trade deficit of 13.6 billion kroons, which is more than half of the total export volume. The foreign trade deficit was offset by surpluses in services and capital account. However, in 1996 the current account deficit increased to 10.3% of the GDP.

Changes in the Economic Structure

It has been a characteristic of Estonian economic reform that no branch of the economy has been preferred; practically the only determining factor in the restructuring has been the ability of an enterprise to adapt itself to economic conditons, especially its ability to orientate itself to the Western market. This situation has been caused by the indeterminate 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 the economy. Economic changes were very much influenced by prices and foreign economic shock. The cumulative decline of the GDP during the period 1990-94 was 36%. The decline in industrial production began in 1991 and was 10% that year. A further decline of 35.6% followed in 1992, a 18.7% decline occurred in 1993, and 3.0% in 1994. During the second half of 1994 the economy started to stabilise.

Economic growth occurred from 1995. The GDP increased in 1995 4.3% and in 1996 4.0%. The industrial output increased respectively by 1.9% and 1.1%. During the first month of 1997 growth speeded up. The GDP increased during the first quarter of 1997 by 10.1%, for the whole year 7-8% growth is expected. Industrial output increased during the first half of 1997 by 12.7%, manufacturing output increased by 16.2% in constant prices. The economic indicators on the Estonian economy are presented in Table 1.

Table 1

Economic Indicators	1992	1993	1994	1995	1996
GDP, billion kroons Real GDP change rate, % Industrial output, change % Consumer price index, % Unemployment* , % Average monthly salary, IV quarter, kroons Exchange rate EEK/DEM Exports, billion kroons Imports, billion kroons Foreign trade balance, billion kroons Foreign trade surplus (deficit)/GDP, % Exports/GDP, %	13,1 -14,2 -35,6 952 1,9 802 8 5,4 5,1 0,3 2,0 41,2	21,9 -8,5 -18,7 35,6 2,6 1165 8 10,6 11,9 -1,3 -5,9 48,4	30,3 -2,7 -3,0 41,7 2,2 2096 8 16,9 21,5 -4,6 -15,3 56,1	41,3 4,3 1,9 28,9 1,8 2697 8 21,1 29,1 -8,0 -19,3 50,8	52.4 4,0 1,1 14,8 2,3 3310 8 25,0 38,6 -13,6 -26,0 47,0

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 1994 the share of agriculture was 7.2% and in 1996 4.8%. Adding to the last figure the share of forestry, the share of these two branches together in the GDP is still only 6.0%. The share of manufacturing decreased to 16.6% in 1994 and 13.8% in 1996. At the same time, the share of trade in the GDP increased from 7.0% in 1989 to 13.5% in 1994 and to 15.4% in 1996, the share of transportation from 6.9% to 10.1% and 9.2% in the same period. The share of financial institutions and insurance captured 2.8% in 1994 and 4.2% in 1996, the real estate, renting and business services respectively 7.3% and 8.7%. The structure of the Estonian GDP has become rather close to that of the GDP of developed countries. As these structural changes are a result of deep economic decline and foreign trade shock (a rapid change of terms of trade, sharp decline in trade with Russia), which was most complicated for industrial enterprises. One very important question is to what extent the share of traditional branches like manufacturing and agriculture can be revived.

Table 2

The Structure of the GDP By economic activities at Current Prices

Economic activity	1989	1994	1996
Agriculture and hunting	22.0*	7.2	4.8
Forestry	.	1.3	1.2
Fishing	.	0.5	0.4
Mining and quarring	1.7	1.6	1.4
Manufacturing	35.1	16.6	13.8
Electricity, gas and water supply	2.0	2.9	3.7
Construction	9.0	5.6	5.2
Wholesale and retail trade	7.0**	13.5	15.4
Hotels and restaurants	.	1.0	1.3
Transport, storage and communications	6.9	10.1	9.2
Real estate, renting and business activities	.	7.3	8.7
Financial intermediation, banking and insurance	.	2.8	4.2
Public administration	16.1***	3.9	3.5
Education	.	5.0	4.7
Health and social care	.	3.1	4.0
Other personal service activities	.	5.1	5.5
Total at basic prices	99.8	87.5	87.0
Net Taxes	0.2	12.5	13.0
Total at market prices	100.0	100.0	100.0

* Forestry and fishing are included into this figure.
** Services of restaurants and hotels are included into this figure
*** Services of financial institutions, insurance, business activities, education, health and social care are included into this figure.

Sources: Rajasalu, T. Estonian Economy at the Dawn of Independence. Tallinn: The Estonian Academy of Sciences, 1992; Statistical Yearbook of Estonia, Tallinn: Estonian Statistical Office, 1997, p. 26.

Foreign Trade

The undervalued (in comparison with the PPP rate) foreign exchange rate of the Estonian kroon, which made the Estonian labor force very cheap (average monthly wage DEM 100 at the end of 1992 and DEM 413 at the end of 1996), was one reason for increasing exports.

Increases in imports have resulted from the increasing purchasing power of the kroon. Increases in exports, on the other hand, have resulted from institutional and structural changes in the economy. Institutional changes ensure access to new markets (this includes free trade agreements with other countries, relationships with new trade partners, and implementing quality control systems which increased the demand for Estonian goods). Structural changes were reflected in the formation of new companies producing high-quality goods and in the adaption of existing companies so that goods and services could be marketed despite increased domestic costs.

Table 3

Estonian Foreign Trade by Regions

Source: Foreign Trade 1996, Tallinn: Estonian Statistical Office, 1997, pp.34-36.

When assessing the impact of the real appreciation of the kroon, one should take into account that Estonian domestic costs have increased, in particular, with respect to prices in industrialised countries (first of all, the EU and EFTA member countries). Exports to those countries accounted for 56,4% of total Estonian exports in 1995 and 54,0% in 1996. At the same time, the kroon depreciated with respect to currencies of several transitional economies (according to the Bank of Estonia, the kroon fell 32% in 1995-96 with respect to the Russian rouble, and 11% with respect to the Lithuanian litas). While such a real exchange rate appreciation in expected because of the higher price level in industrialised countries, it will still decrease the competitiveness of the Estonian export industry in those countries. As a result, exporters whose competitiveness has fallen, face pressure to move towards the markets in the East. The appreciation of the US dollar with respect to the German mark in 1996, and in the first months of 1997 favourably affected Estonian exporters, because the depreciation of the mark was effectively translated into the depreciation of the kroon.

Finland played a very important role in Estonian foreign trade. That trade was encouraged by some knowledge about these markets and linguistic closeness. Finland also acted as an intermediator for Estonian entrepreneurs. Several products imported from Finland are only packed or processed there (vegetables for example) but registered as Finnish import. On the other hand, also some part of Estonian exports is transferred from Finland to other countries. Finland accounted for 18.3% of Estonian exports and 29.2% of imports in 1996. Russia’s share of Estonian foreign trade declined dramatically in 1992, but it has been rather stable since. Russia contributed 13.5 per cent of the Estonian imports and received 16.4 per cent of the Estonian exports in 1996. Estonia is also restoring connections with its traditional trade partners, Sweden and Germany. Trade with the other Baltic countries, Latvia and Lithuania, has been modest.

By commodity group, the leading article of Estonian export has been textiles (14.3% of the total export in 1996). The most important commodity within the group was clothes. A big share of this export was made up of semi-finished products produced by Estonian enterprises under subcontracts for Finnish and Swedish firms. Machinery, mechanical appliances and electrical equipment accounted for 13.4% of the Estonian exports in 1996. The most important item was electrical equipment (parts and units of radio, television and communication equipment). The most important export markets for these products were Finland, Russia and Sweden. The next most important exported commodity was timber and timber products (11.4% of total exports), which were exported to Finland, Sweden and Great Britain.

In the structure of Estonian imported machinery, mechanical appliances and electrical equipment was the leading commodity group with 21.9% of the total import in 1996. The most important item was electrical equipment (parts and units of radio, television and communication equipment). Electrical equipment for telecommunication ranked second among the items of this commodity group. One reason why the share of these items is high both in export and import is the flow of materials and parts between foreign enterprises and their Estonian subcontractors.

The second most important commodity group in Estonian import is mineral products with 9.8% in 1996. The dominating items are mineral fuels (approximately three quarters of the import in this group) and gas (one quarter).

Textiles and textile articles constituted 9.4 per cent of import in 1996. Cotton and articles thereof was the largest single article in the total import in this group.

Conclusions

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

The structure of the Estonian GDP has become rather close to that of the developed countries. As these structural changes are the result of a deep economic decline and foreign economic shock, even more complicated for industrial enterprises, one very important question is what the share of traditional branches like manufacturing and agriculture will be after some revival of these branches. The state´s economic policy will play an important role in these changes.

Estonian comparative advantages have been related mainly to its cheap labour costs and low prices of other inputs such as electricity, wood, and metals. In part this cost-effect has been achieved due to import of these inputs from some other low-price area (Russia). Undervaluation of the Estonian kroon has been one macroeconomic factor creating this phenomenon of cheap inputs, but because inflation and increasing wages make Estonian inputs more expensive, this comparative advantage will grow smaller and could even eventually disappear, especially for labour-intensive industries. New investments and structural changes in the economy are the main factors leading to the competitiveness of the Estonian economy on the level of increased costs of inputs.

...