Journal of Undergraduate Research
Volume 7, Issue 4 - March/April 2006

Effects of Economic Integration on Estonia’s Economy

Julia Palfi

ABSTRACT

Several changes have taken place in Estonia’s economy since its split from the Soviet Union. Estonia has made institutional and structural changes, such as privatization, that have raised its gross domestic product (GDP). Also, the adaptations it made to its economy in order to abide by the convergence criteria to join the European Economic and Monetary Union have had an overall positive effect on its economy. Recently, Estonia’s economy has only improved with each current year, showing that free trade has had a positive impact on the country. This paper gives a general overview of the Economic and Monetary Union, including the requirements countries have to meet in order to join the Union, and a general overview of the recent Estonian economy. Then the paper compares fundamental economic factors including inflation rate, government debt, public deficit, interest rates, and GDP growth among Estonia, the Euro Zone, and the United States. This data analysis gives the reader perspective on recent changes in the Estonian economy as well as Estonia’s general success in conforming to the criteria necessary for it to eventually adopt the Euro in 2010.

INTRODUCTION

Major changes have taken place in Estonia’s economy since its split from the Soviet Union. At the center of all of these changes is Estonia’s adoption of free trade. The developments that occurred in the past several years have not only caused improvements in key economic factors in Estonia, such as productivity, but have also aided Estonia in conforming to the criteria necessary for it to eventually adopt the Euro in 2010.

Only a few studies of the transformations that have taken place in Estonia’s economy after its liberalization in 1991 exist. The country positioned itself as the intermediary between the East and the West, while changing its economy to be more Western. It encouraged foreign investment and even created an electronic Stock Exchange. Estonia joined the World Trade organization in 1999 and the European Union (EU) in 2004 (U. S. Department of State, 2005). Estonia has privatized virtually all of its industries and made other changes to deregulate its economy (Weber, 2000). During the past decade, Estonia first pegged its currency to the German mark and subsequently the Euro. The peg to the Euro should make the transition to using the Euro as the official currency of Estonia much easier (Kraft). This paper combines information on recent changes in the Estonian economy with analysis of Estonia’s general success in conforming to the criteria necessary for it to eventually adopt the Euro.

BACKGROUND ON ECONOMIC AND MONETARY UNION

The Economic and Monetary Union (EMU) is an agreement for a common currency among the European countries that was created in 1989. This currency, the Euro, is managed by the European System of Central Banks (ESCB). The ESCB includes the European Central Bank and twelve other national central banks. The ESCB was created to be free of political bias on behalf of any country. Therefore, although it is obligated to report to the European Parliament, it is not under the jurisdiction of that institution. One of the reasons for these precautions against possible political partiality is that, previously, the many currencies among the European States that were prone to inflation were pegged to the German mark; because of this, the German Bundesbank controlled the monetary policy and was understandably biased in making decisions that were best for Germany but not necessarily for the other affected European countries.

The initiatives that led to the eventual creation of the Economic and Monetary Union started with the establishment of the European Monetary System (EMS) in 1979. The EMS focused on limiting its member states’ exchange rate fluctuations by creating a system of mutually pegged exchange rates. This agreement also initiated the free flow of expenditure and capital among the European countries, which was one of the initial steps toward the eventual establishment of the EMU (Krugman & Obstfeld, 2003). In 1990, controls on the transfer of financial capital among the EU countries were removed. Moreover, in 1992 EU countries took an additional step by further promoting trade among the EU countries through the free flow of goods, services, and factors of production. Another stage of the transition took place in 1994 with the establishment of the European Monetary Institute (EMI). Its main tasks were to supervise the monetary union of Europe and to eventually become the central bank of Europe. In 1999, the Euro was released into circulation and, subsequently, the EMI was converted into the European Central Bank (Dinopoulos & Petsas, 2000). All of the aforementioned steps aided the European countries in furthering their financial integration by transitioning from the EMS to the EMU. This decision was made for the following reasons: to eliminate the uncertainty and currency exchange costs resulting from the use of different currencies, to avoid bias for any particular country by having a European Central Bank with no political ties, to combine the benefits of having fixed exchange rates and the free movement of capital, and to create economic ties that would prevent possible political friction that had led to wars in the past.

The plan for a European EMU was originally created by a committee headed by Jacques Delors, the contemporary president of the European Commission. The Member States of the European Union gave up their national currencies and join the Economic and Monetary Union for two reasons. First, the European countries wished to unite in order to become a noteworthy monetary power that could compare with countries such as the United States. Second, the countries wanted to eliminate the remaining barriers to trade that were in large part due to exchange rate uncertainty among the European countries (Krugman & Obstfeld, 2003).

The single European currency was finally created through the Maastricht Treaty in 1991. The coins of the currency represent the entire Union but still pay tribute to the individual member states by portraying national symbols of the country of issue on one side. The Treaty specified certain standards that the member states had to meet in order to be able to adopt the Euro as their currency. These include price stability and certain restrictions on government finances, long-term interest rates, and exchange rates. Price stability means that during the year prior to the one in which a country’s eligibility is considered, the inflation rate of that country cannot exceed those of the best-performing member states by more than one and a half percentage points. The government finances requirement stipulates that the yearly government deficit to gross domestic product (GDP) percentage cannot be more than 3% over the deficit of the previous year. If this stipulation is not met, the deficit must at least approach 3% or show a general downward trend toward 3% or lower. The requirement also specifies that the government debt-to-GDP ratio should not exceed 60% at the close of the previous year or at least be decreasing to approach the 60% mark. Also, in the year prior to consideration for membership long-term, interest rates cannot exceed those of the best-performing member states by more than two percentage points.

Each country wishing to join the EMU must have also been a part of the exchange rate system of the European monetary structure without problems and cannot have deliberately devalued its currency during the two years prior to being considered for membership (Europa, 2003). Countries that seek to join the EMU in the near future have the option of joining ERM 2. ERM 2 is an updated version of the previous exchange rate mechanism that involved a system of mutually pegged exchange rates. It allows the country to fix its exchange rate to the Euro with a leeway of +/- 15 % while still having the option of suspending the pegged exchange rate if the country feels the rate is no longer beneficial to its domestic monetary policy (Krugman & Obstfeld, 2003). This was not the first set of standards imposed on the EU countries. In 1997, the Stability and Growth Pact (SPG) set fiscal policy standards for countries that included low government budget deficits and planned penalties for countries that failed to uphold the budget deficit goals (Dinopoulos & Petsas, 2000).

The theory of optimum currency areas aids in understanding the incentive the European Member states had for wanting to have fixed exchange rates via the EMS and finally even a common currency through the EMU. This theory states that the higher the economic integration among the countries, the more they can benefit from fixed exchange rates. There are other benefits as well. For instance, a monetary efficiency gain arises from fixed exchange rates due to the elimination of uncertainty and transaction costs (Krugman & Obstfeld, 2003). The Commission of the European Communities found that the instatement of a single currency can bring a savings of up to one percent of a nation’s income to a country (Dinopoulos & Petsas, 2000). The gain directly varies with the amount of trade among the countries who fix their exchange rates. The countries of the EU have close trade ties and, in terms of capital, can even qualify as an optimum currency area, or a group of countries that in engages in high trade of goods and production factors. Furthermore, a researcher from UC–Berkeley found that countries that have stable exchange rates experience much higher levels of trade amongst each other than they would otherwise. In addition, if they belong to a common currency union, their level of trade with each other is three times as much as with countries outside of the union. A problem can only arise if the currency to which other currencies are pegged is less stable than the latter currencies, which is not the case with the Euro.

Joining an exchange rate area also has its shortfalls such as the economic stability loss, the loss that results when a country is no longer able to stabilize its output and employment through the manipulation of the monetary policy and exchange rate. Fortunately for the European States, the economic stability loss varies indirectly with the amount of trade among countries who fix their exchange rates. For example, if a country is experiencing output market disturbances which can lead to high unemployment but engages in high trade with the rest of the EU, even a slight drop in its prices will lead to a great increase in demand across all of EU; therefore, employment in that industry will increase to a more favorable level. In addition, having closely related economic markets greatly eases the ability of unemployed workers to find employment abroad. Similarly, free capital flows would allow countries to invest in the booming businesses in the country creating further employment and production output. So it seems the benefits of the creation of the EMU greatly outweigh the costs (Krugman & Obstfeld, 2003).

BACKGROUND ON ESTONIAN ECONOMY

The relatively recent transitions that have taken place in the Estonian economy clarify why it is only natural for the country to want to join its European counterparts as a member of the Economic and Monetary Union. Estonia applied to join the EU in 1995 and officially began its accession process in 1998. Several changes have taken place in Estonia’s economy since its split from the Soviet Union. First of all, unemployment decreased to 10%. Also, the amount the government takes out in loans has been relatively small mainly because tax revenue has been exceeding government expenditure. In addition, virtually all residential buildings were privatized and became owned by their inhabitants. The use of technology has grown rapidly, and in 2003 approximately 45% of Estonian residents had Internet access. Most companies rely on the use of computers and all records are kept electronically. Even government meetings occur through the computer.

Several other facts about Estonia’s economy are noteworthy. Estonia’s present currency is the kroon whose exchange rate with the Euro is 1 euro = about 15.6 kroons. Foreign countries invest in Estonia for several reasons. The recently more stable economic environment assures investors that their funds are safe, and the Estonian government provides many tax incentives for investors. For instance, investors pay only a small income tax for business ventures and no income tax on invested earnings. Among these foreign investors are Sweden (about 39% of direct investments) and Finland (about 27.5% of direct investments). Foreign investors mainly invest in the Estonian financial sector, but they also place money into transport and communication, processing industries, trade, and services sectors.

The Bank of Estonia is Estonia’s central bank that was founded in 1919. Estonia has a currency board arrangement which requires that for each kroon in circulation, the Bank of Estonia is required to keep an equivalent amount of euros, dollars, or gold in order to guarantee the steadiness of the monetary system. Banks make up the bulk of Estonia’s financial sector. Therefore, they own most insurance, leasing, and investment companies. As mentioned earlier, most foreign investments are made in the Estonian financial sector, so the majority of banks are supported by foreign funds.

The Estonian government collects 87% (in 2003) of its proceeds through taxes. Among these taxes are the value added tax (18%), the personal income tax (26%), and the corporate income tax (26%). Most government spending funds social programs and benefits, such as health care and pensions. However, some costs are incurred in infrastructure costs such as road construction (Estonian Institute).

ANALYSIS OF RECENT ECONOMIC CHANGES IN ESTONIA

Inflation in Estonia was high in the past due in part to the fixed exchange rate system in place through the currency board arrangement mentioned earlier. The prices of non-tradable domestic products had to be adjusted to those of European Union, Estonia’s largest trade partner, thus causing inflation in Estonia. However, Estonia adjusted the types of goods and services it produced to better cater to the demands of the EU. Exports and direct investment increased, and as Figure 1 shows, inflation began to decline from 48% in 1994, to 11% in 1997, to 3% in 2004. In the most recent decade, Estonia’s inflation closely followed that of the EU and US. Estonia’s latest inflation percentages abide by the convergence criteria for the most part. In years such as 2003 Estonia’s inflation rate actually was lower than the Euro Zone, 1% in Estonia compared to 2.1% in the Euro Zone. However, in 2001 and 2002, Estonia’s inflation exceeded that of the Euro Zone by more than 1.5%. In 2001, Estonia was at 6% compared to 2.4% of the Euro Zone, and in 2002, Estonia was at 4% compared to 2.3% of the Euro Zone.

Figure 1. Annual Inflation Rate Comparison among Estonia, Euro Zone, and United States
Source: Eurostat, World Development Indicators database

Figure 2 shows that Estonia’s government debt-to-GDP ratio has closely followed the trends of the Euro Zone and the United States. However, overall it has remained relatively steady at about 5%, significantly lower than the Euro Zone which averaged about 72% and the United States which averaged about 41%. These statistics put Estonia well in conformance with the government debt requirement specified in the convergence criteria in which state debt–to-GDP ratio must be 60% or below.

Figure 2. General Government Debt as a Percentage of GDP Comparison among Estonia, Euro Zone, and United States. Source: Eurostat, World Development Indicators database, U. S. Government Printing Office

Figure 3 shows that the public deficit as a percentage of GDP of Estonia has varied somewhat from that of the Euro Zone. This variance perhaps can be attributed to the European Union being one of Estonia’s largest trade partners; whenever EU’s trade deficit fell, Estonia’s rose. Hence, the public deficit was also inversely proportional between them. The peak in Estonia’s deficit as a percentage of GDP could be the result of the Russian financial crisis of 1999, which affected Estonian industries that exported to Russia. The only years in which the deficit exceeded 3% over the previous year as specified in the criteria were 1995 and 1999. In 1995, the country was still stabilizing its newly liberated economy, and in 1999 it faced the negative effects of the Russian financial crisis. However, provisions in the criteria specify that as long as a percentage of three or lower is approached at all times, the country is still considered in conformance.

Figure 3. Public Deficit as a Percentage of GDP Comparison among Estonia, Euro Zone, and United States. Source: European Central Bank, Eurostat, U.S. Government Printing Office, South Bank University

Figure 4 traces 10-year interest rates of Estonia’s Treasury Bill equivalent securities. Until 1999 the Estonian interest rate was fixed to the German mark. In 1999, it transitioned to be fixed to the Euro. This transition could explain why the inconsistent behavior of the interest rates in Estonia started to closely mimic those of the Euro Zone, and the United States for that matter, in 1999 and after. Therefore, it is quite clear that the interest rates meet the EMU convergence criteria because they are actually below those of the Euro Zone in 1999 and later.

Figure 4. 10-year Treasury Bills Interest Rates (Treasury Equivalent Bills in Estonia) Comparison among Estonia, Euro Zone, and United States. Source: Federal Reserve, Eurostat, Bank of Estonia

Finally, Figure 5 shows the annual percentage growth of Estonia’s GDP which generally follows the trends of the Euro Zone’s GDP growth. The overall increase in the past decade can be attributed to several factors. First, the institutional and structural changes, such as privatization, that took place when Estonia split from the Soviet Union helped boost GDP. These changes combined with technological advancement helped improve productivity. Thus, overall production and exports increased, increasing GDP. Figure 5 also shows that Estonia’s GDP growth has exceeded that of the Euro Zone for most of the years in the past decade. However, in 1994, Estonia’s GDP growth rate of -2% was the lowest rate of the past decade and was probably due to Estonia’s recent split from the Soviet Union. At that time, Estonia had not instituted all the changes necessary to have a healthy open trade economy. The leap to 11% in 1997 could be explained by the progressive economic changes Estonia made after the split. Finally, the drop to 0% growth in 1999 can more than likely be attributed to the Russian financial crisis of 1999 (Estonian Institute).

Figure 5. Growth of GDP as % Comparison among Estonia, Euro Zone, and United States. Source: World Development Indicators database

CONCLUSION

Estonia’s adoption of free trade has brought about many positive changes in the Estonian economy. The inflation rate and government deficit have experienced an overall downward trend during the past decade. In addition, the overall decrease in long term interest rates can be interpreted to show that expectations of future inflation are low. The debt-to-GDP ratio has conformed to the EMU convergence criteria at all times, while the inflation rate, deficit to GDP ratio, and Treasury interest rates have conformed for most years. Furthermore, GDP growth has increased because of increased productivity and other factors such as technological advancement. In fact, Estonia’s GDP growth has for the most part exceeded that of the Euro Zone in the latest years. Clearly, the adoption of free trade has both boosted Estonia’s economy and aided Estonia in conforming to the criteria necessary for it to eventually adopt the Euro.

Estonia is well on the way to joining the Economic and Monetary Union. Besides conforming to the convergence criteria, Estonia has made many progressive changes to its economy since its separation from the Soviet Union. For instance, it has privatized everything from its banks to its transportation systems. The free market economy has helped boost GDP and made reaching the goals set by the European Union more realistic achievements.

Economic trends show that Estonia is on track to fulfilling the convergence criteria. Its government is putting forth a great effort to make sure that Estonia is on course by adapting its economy and supporting factors, such as the country’s infrastructure. In the next few years, Estonia’s economy will stabilize even further, allowing it to be completely in compliance with the convergence criteria.

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