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Thursday, March 1, 2007

Estonia's Economy in Perspective

by Aapo Markkanen (Tampere) and Edward Hugh (Barcelona)

Estonia is a land of apparent contradiction. At one pole it is a budding centre of new technology initiatives, as typified by the much lauded presence of Skype, and at the other it is at the front end of one of Europe's most modern problems, population ageing and decline. So Estonia is a kind of living contradiction: a rapidly ageing society apparently run by young people (although it is worth bearing in mind that, when it comes to the economy, the entire software industry of the country employs a mere 2,500 people out of a total population of 1.35 million). As an example of the 'youthful side' of Estonian life it is worth noting that Mart Laar, who may well be the most visible 'personality' of the last decade in Estonian politics, was only 32 when he became prime minister in 1992, and the ministers of defence and intererior in his cabinet were even younger -26 and 27, respectively. Things are already changing here, however, since candidates for this month's elections have and average age of 46.7 which is still rather juvenile by some standards, but is, for example, three months older than their equivalents in Finland, which is in fact about to choose its own parliament two weeks from now. So everyone ages, even in Estonia.

Part of the explanation for this early 'youthful' phenomenon can be found in the nature of Estonia's transition to independence and full EU membership. Prior to independence Estonia's Russian speaking population (which constitutes some 400,000 of the present total, although not all of these, by any means, are full Estonian citizens) had a rather disproportionate influence in the country's affairs. With the arrival of the independent Estonian state in 1991 this group became rapidly discredited, and as a result a gap opened up into which a group of young ethnic Estonians entered enthusiastically, and with some fresh vision - when Mr Laar was sworn in fifteen years ago, Milton Friedman's Free to Choose was the only book of economics he had ever read. Many of these people were indeed only in their twenties and early-thirties at the time, and symptomatic of this new generation and its reach is the fact that the current mayor of Estonia's capital city - Tallinn - is still only 29. Yet do not forget either that Estonia enjoyed here some of the benefits of hindsight, since it only started its transition two years after the post-socialist states in Central Europe, and thus was able to critically examine some of the lessons which had already been learnt.

These facts perhaps explain why the 'reform process' went so far and so fast in Estonia, and this in many ways sets Estonia apart from its Baltic cousins Latvia and Lithuania. Perhaps the most evident single indication of just how far the process went is to be found in one single fact: in 2005 total government accumulated debt (yes debt, not the annual deficit) constituted just 4.6% of GDP. And the transition hasn't been only an economic one since it has also involved important canges in the legal system and civil service as witnessed by Estonia's ranking in the newest Transparency CPI which at 24th positition is more or less remarkable among the post-socialist regimes. Regardless of what are the perceptions from the Kremlin, Estonia has also made extensive efforts to integrate its Russian speaking minority, as can be seen from this (pdf) report.

So on the face of it all is well. Estonia's GDP grew in 2006 at an annual rate of 10.7%, and over the 5 year period from 2002-2006 averaged something in the region of 8.5%. Indeed, as can be seen from the chart below, Estonia has even been doing comparatively well when compared with its other East European EU accession counterparts.

And the people are living much better than they were. In expenditure terms, domestic demand constitutes the principal driver of growth, rising by 11.5% year on year in 2006. Of this total consumer demand continues to grow very strongly, with consumer expenditure up in 2006 by 14.5%.

Consumer price inflation - which is one of the principal present obstacles to Estonia's Euro membership - has not been dramatically high (given the rise in oil prices and the very rapid growth rates) when compared to many actual zone members (Spain and Greece, for example) and has been running in the 3 to 4.5% range (see chart above), and while this issue needs to be addressed it is hardly a case of having the house on fire.

Indeed part of the problem here stems from the Estonia's very Euro membership ambitions themselves, since the existence of Estonia's currency board regime (which is the guarantee that the kroon remains pegged to the euro at the rate of 15.6466:1) effectively limits the ability of the central bank to influence the economy through monetary policy. Instead, the BoE is reduced to attempting to influence monetary conditions through regulation of the banking sector and lobbying of the government to ensure they run a restrictive fiscal policy. As a result bank lending, and especially for property, has been growing strongly (see chart below).In response to this situation, the BoE raised reserve requirements on Estonian banks from 13% to 15% in September 2006, but the results of this are still effectively to be seen.

So the short term outlook is indeed reasonably healthy, but it is in the longer term, and particularly in the context of the capacity constraints imposed by population ageing and decline, that the doubts start to arise. As is by now reasonably well known Estonia's is in decline, and has been for some years. According to the CIA factbook, the population fell at a rate of 0.64% per annum in 2006. Part of the problem is that there are less children being born, and part is that there is a negative net balance on migration (which was thought to have been at a rate of 3.2 people per thousand leaving in 2006). This is not an entirely recent phenomenon, since deaths became greater than births in Estonia in 1992, and fertility remains stubbornly low in the 1.3 - 1.4 range. To be sure Estonia has made some effort to address this situation with a kind of cash-for-children policy, and live births were up in 2005 and 2006, but, if international experience is anything to go by, such policies can only affect numbers on the margin, and a more substantial shift requires a much more systematic approach, and of course only has effects in the long term.

Indeed in the short term the only big change which may be on the horizon is a kind of 'death displacement' effect, since life expectancy in Estonia at 72.04 is still comparatively low by West European standards, and hence there is a lot of room for medically and technologically driven improvement, but while these will only be welcome from a human point of view, the economic consequences of such an increase in life expectancy are far less clear.

To be sure with the low level of public debt there is plenty of slack which can be absorbed by improving the quality of health care, but it will be necessary to find revenue streams to pay for this, and it is noteworthy in this context that there are already proposals on the table to start to modify the 'flat-tax' for which Estonia has become so famous.

Estonia's median age (39.3) is still not especially high, but it is set to rise rapidly. As such we might expect the Estonian economy to come to rely increasingly on exports as this process works its way through, and indeed Estonia does have a very open economy, with exports of goods and services constituting some 80% of GDP by value in 2006 (and imports some 86%, hence the trade deficit), so it is possible for them to make this structural shift, and indeed once the presnt 'growth spurt' wave comes to an end, this is what we should expect to happen. However to make the potential a reality there are a number of important issues which Estonia will first need to address, and the most important of these is the long term capacity problem associated with labour supply.

If we look at the present situation we will see that investment spending has been strong - with gross fixed capital formation running at 31% of GDP in 2005 - although it does seem to have lost some of its momentum of late. Part of the problem which arises in maintaining this very rapid rate of domestic capital formation is the availability of labour, and especially labour with the appropriate skill set. The Estonia unemployment rate is still comparatively high (in the 6 - 8% range), but it has been falling steadily (and if the current rates of growth are sustained it will fall substantially in the next few years), and there are evident signs of shortages of skilled workers in key areas. Estonia!s growing labour shortage has already hit machinery
production, and especially in the area of communications equipment. Elcoteq, the Finnish mobile telephone assembler - which is Estonia's largest exporter - has often complained about difficulties in recruiting skilled labour. Although Elcoteq denies that it has any intention of shifting its activities away from Estonia, the company has now stopped expanding production in its Estonian plants. And as Estonia strives to move up the value chain employment in wage-sensitive industries - such as textiles and leather goods - has been in decline for some years now, with even domestic firms moving production to cheaper locations abroad. Another evident by-product of the growing labour scarcity is the rate of annual increase in monthly salaries, which is now in the 12 - 14% range.

Now evidently the rapidly falling unemployment rate is a result of a number of factors, most important among which are the high rate of economic growth and a declining population, and it is the combination of these which raises all the questions about longer term sustainability. Clearly Estonian companies can overcome labour supply difficulties by outsourcing activity elsewhere, and this to some extent is already being reflected in outward capital movements (see below), which of course negatively impact the external balance in the short term since the inward income stream generated is initially significantly less than the outflow.

As Claus has been indicating time and time again, the implications of such structural shifts are also important in terms of their impact on domestic consumer demand, and few, at this stage, seem to be focusing on the implications of all this.

Another of Estonia's big ongoing worries is the level of the trade deficit -which in recent years has been hovering around 12 per cent of GDP (see graph below), and this is estimated to reach around 19% of GDP in 2007. Insofar as this trade deficit is fuelled by demand for new machinery and equipment (which constituted 31% of imports by value in 2005) then the situation is neither surprising or especially troublesome, but the problem is that the consumption-driven boom has also been increasing the demand for consumer imports, whereas the continuously rising wages have been leading foreign manufacturers, mainly from Finland and Sweden, to outsource further afield. Salaries are expected to continue their rise as unemployment - which is forecast to fall to around 4% in 2007 - comes down; the average salary, 573€ a month at the end of 2006, is expected to reach the 700€ mark by 2009.

Another aspect of the external account position (in addition to the trade deficit) is the widening of the current account deficit and, in particular, the fact that the deficit on the income account has increased substantially. The rapid growth of the Estonian economy has led to a sharp rise in corporate profits, especially among foreign-owned firms. As a result, the deficit on investment income rose by USD107m y-o-y to USD224m y-o-y in the third quarter of 2006. This worsening of the income stream situation has also been accompanied by a deterioration in the capital flow balance.

Estonia continues to be a net recipient of foreign direct investment (FDI), but, as we have noted, investments by Estonian firms abroad are rising. As a result, the net inflow of FDI in the 12 months to September 2006 was USD254m, or just 16% of the current account deficit over the period. With investment in portfolio assets continuing to record a net outflow, the substantial current-account deficit was, in effect, financed by a further large inflow of "other investment" - mainly foreign borrowing by Estonian banks.

Emigration has played its own part, of course, and some 11.000 Estonians, out of the total population of 1.35 million, were working abroad last year -which sounds negligible when we compare this for example with Lithuania (which has more than 400.000 EU expats out of a total population of 3.4 million). The overall migration picture in Eastern Europe is a complex and worrying one, as Claus has already indicated here.

In fact Estonia's loss of workers to richer EU states following accession in 2004 has been estimated by the World Bank at 1% of the working age population, which is the lowest rate for any of the Baltic states. Yet, in interpreting these numbers, one has to also consider the already high median age of 39.3 years and the fact that those leaving have mainly been badly needed young vocational professionals. Next-door neighbour Finland opened its labour market fully just last year, so the flow is likely to only become stronger. Moreover, Estonia suffers from the same malaise as many of its more western couterparts, it has a skewed education system that delivers too few vocational graduates and too many academics (for example, during the years 1995 and 2004 the number of vocationals - per 10.000 people members of the population - increased from 205 to 222, whereas in the tertiary level the leap was from 191 up to 502) and, as an overall result, the country is predicted to face a serious shortage of such workers by year 2015.

One obvious solution, since the salaries and living standards are now catching-up rapidly, might be for Estonia to start attracting workers from other EU countries. The sustainability of its flat-rate tax model is - as has been indicated - debatable, but one advantage (besides the IT-readiness stressed in Manuel's post) that Estonia certainly does have is its geography. Tallinn is only a 80km ferry trip away from Helsinki and, economically speaking, these two regions are already highly integrated -and then there's also St Petersburg lying out there to the East. The future and wealth, to a large extent, of the whole Baltic region depends on how well these centers of growth can network together.

So can Estonia pull it off? This, as in so many other cases, depends. Certainly we are now entering unknown territory. At some point the growth catch-up spurt will come to an end, and the capacity constraint problem will begin to take hold. Whether of not Estonia's leaders will still be young enough and agile enough to respond to the challenge remains to be seen. Certainly a sustainable path is there - via a leveraging of inward migration, outsourcing, networking and a move towards higher value work. When we speak of reform in the Estonian context it is these issues we should be thinking about. The future has that intriguing dimension that is always and ever an unknown entity. Let's just hope that in Estonia's case the upside potential has a greater impact than the downside risk.

Source: Finpro, Finnish Trade Center; Estonia country report 2006