by Manuel Alvarez-Rivera: San Juan, Puerto Rico
Estonia will be holding a parliamentary election on March 4, 2007, with advance voting taking place on February 19-23. The election will be the fifth legislative poll since 1991, when the country, along with neighboring Latvia and Lithuania, recovered its independence following fifty-one years of annexation by the Soviet Union. But voters in the smallest and northernmost of the three Baltic republics didn't need go to the polls to choose members of the country's 101-member unicameral Parliament, the Riigikogu, since on February 26-28 they were able to cast electronic votes, or e-votes, using Internet-connected personal computers equipped with an ID card reader.
E-voting also allows voters to change their vote by re-voting electronically, or by voting in a polling place. In either case, only the last vote cast by the elector will be counted, and any previously cast e-vote shall be deleted.
Internet voting was introduced in Estonia for the first time in the 2005 municipal elections. However, only 1.85% of the voters - 0.88% of the electorate - cast an electronic vote in the event, whereas 3.4% of the electorate cast e-votes in the 2007 parliamentary election, according to preliminary figures published by Estonia's National Electoral Committee.
Members of the Riigikogu are elected for a four-year term of office by universal suffrage and proportional representation (PR) in twelve multi-member constituencies, where electors vote for a specific candidate within a party list. Nonetheless, the overall distribution of parliamentary mandates is determined on a nationwide basis: Riigikogu seats are apportioned among parties polling at least five percent of the vote (electoral coalitions are not allowed since 1999), according to a modified form of the largest average method, which replaces the traditional d'Hondt divisors (1, 2, 3 and so on) with the series 10.9, 20.9, 30.9, etc. This procedure, mathematically equivalent to elevating the number of votes polled by each qualifying party to the power 1.111111... - 10 divided by 9, that is the reciprocal of 0.9 - and then distributing the seats according to the standard d'Hondt rule, favors the largest parties at the expense of the smaller ones: simply put, the increase brought about by exponentiation becomes larger as the number of votes increases.
In practice, the application of this unusual formula hasn't had much of an impact in the composition of successive Estonian legislatures: compared to the traditional d'Hondt method, the larger parties have usually picked up between one and three extra seats each, while smaller parties have lost no more than one seat apiece.
The five percent threshold and the modified PR rule notwithstanding, Estonia's post-independence party system has been characterized by a high degree of fragmentation and volatility, and the country has been ruled by a succession of shaky coalition cabinets which have lasted on average just over a year in office - a problem common to all three Baltic republics during both their present and preceding periods of independence. Nonetheless, center-right governments have been the norm in post-independence Estonia, except from 1995 to 1999, when the now-defunct, center-left Coalition Party was the country's dominant political force.
The results of the last Riigikogu election, held in March 2003, gave some tentative indications of increasing party stability. In the election, the minority center-right coalition government of the Estonian Centre and Reform parties that had been in power since the beginning of 2002 managed to improve its parliamentary standing, in stark contrast to the 1995 and 1999 legislative elections, when the incumbent parties at the time were soundly rejected at the polls. Nonetheless, the ruling alliance ended up being replaced by another center-right coalition comprised of the new, anti-corruption Res Publica, the Reform Party and the People's Union. However, the new government, headed by Juhan Parts of Res Publica, lasted only two years in office: in March 2005 it lost a parliamentary vote of confidence and was subsequently replaced by yet another right-of-center coalition government of the Centre Party, the Reform Party and the People's Union, led by Andrus Ansip of the Estonian Reform Party.
The ruling coalition went on to poll strongly in municipal elections held later that year, but Res Publica (Latin for "Public Matter"), which had emerged as the second largest party in the 2003 legislative vote (when it tied with the Centre Party as the largest parliamentary force), fared poorly and subsequently merged with an older conservative party, Pro Patria Union. As a result, there are now only five parties represented in the Riigikogu: Union of Pro Patria and Res Publica, Estonian Centre Party, Estonian Reform Party, Estonian People's Union, and the Social Democratic Party.
Like neighboring Latvia, Estonia has a sizable number of ethnic Russian inhabitants (as of 2006, just over a quarter of the country's declining population), but many of them do not have Estonian citizenship and cannot vote in parliamentary elections. In the 2003 Riigikogu election, the largely Russian-speaking Estonian United People's Party (now the Constitution Party) fell below the five percent threshold and lost its legislative representation. As in Latvia, the integration of what remains a significant Russian minority continues to be a major problem that has called the attention of Amnesty International. This issue also has foreign policy repercussions: Russia routinely accuses Estonia of discriminating against ethnic Russians, and relations between both countries remain tense, all the more so since Russia stubbornly clings to the fiction that Estonia (along with Latvia and Lithuania) voluntarily sought annexation to the Soviet Union in 1940.
Despite frequent cabinet upheavals since regaining independence, Estonia has consistently pursued a foreign policy strongly oriented towards the West in general and the European Union (EU) in particular. In light of its poor relations with Russia - not to mention the painful memories of the 1940-91 annexation to the U.S.S.R. - it came as no surprise that Estonia eagerly pursued membership in the EU as well as the North Atlantic Treaty Organization (NATO), securing both in 2004.
Likewise, Estonia has re-oriented its trade towards the West, forging a particularly strong relationship with neighboring Finland - a country with whom Estonia shares a linguistic affinity, as the Estonian and Finnish languages are closely related. Although the Estonian economy has been performing strongly in the years since independence, the country remains among the poorest members of the European Union.
All the same, Estonia has become the first country in the world to hold a national legislative election using the Internet as a means of voting - a high-tech initiative that may be a harbinger of things to come.
Update
Estonia's National Electoral Committee reports complete preliminary results of the March 4, 2007 Riigikogu election were as follows:
Reform Party - 153,044 votes (27.8%), 31 seats
Centre Party - 143,518 votes (26.1%), 29 seats
Pro Patria and Res Publica Union - 98,347 votes (17.9%), 19 seats
Estonian Social Democratic Party - 58,363 votes (10.6%), 10 seats
Estonian Greens - 39,279 votes (7.1%), 6 seats
Estonian People's Union - 39,215 votes (7.1%), 6 seats
Estonian Christian Democrats - 9,456 votes (1.7%), no seats
Constitutional Party - 5,464 votes (1.0%), no seats
Others - 3,527 votes (0.6%), no seats
Voter turnout stood at 61%, up from 58.2% in the 2003 parliamentary election.
The Estonian Reform Party of Prime Minister Andrus Ansip emerged as the election's big winner, increasing its parliamentary representation from 19 to 31 seats and displacing the Centre Party - which picked up an additional seat - as the country's largest political force. However, the Union of Pro Patria and Res Publica suffered a major setback, losing sixteen seats with respect to the overall total won by its component parties in 2003 (when they ran separately); nonetheless, the merged party retained significant electoral support.
In all, six parties are represented in the new Riigikogu: Reform, Centre, the Pro Patria and Res Publica Union, the Social Democrats (who increased their representation from six to ten seats), the People's Union (who lost seven of their thirteen seats) and the Estonian Greens, who secured parliamentary representation on their electoral debut.
Although the Reform-Centre-People's Union coalition government won re-election with an enlarged legislative majority, the ruling parties didn't form another government, due to differences between Reform and the Centre Party over Estonia's flat tax system. In April 2007 - one month after the election - incumbent Prime Minister Ansip formed a new center-right coalition government composed of his Reform Party, the Pro Patria and Res Publica Union, and the Social Democrats.
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
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
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