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Estonia

Author(s):
International Monetary Fund
Published Date:
June 1996
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I. Introduction

Following a sharp decline in output and high inflation associated with the breakup of the Soviet Union and transition to a market economy, Estonia’s economic recovery started in mid-1993 and gathered momentum during 1994. Rapid export growth and strong investment demand associated with large inflows of foreign direct investment led the economic upturn. While the annual inflation rate has fallen sharply since 1992, the monthly rate rose somewhat in early 1994, mainly owing to adjustments in administered prices. However, robust foreign direct investment, coupled with the highly skilled labor force, facilitated the transfer of technology and the renewal of the obsolete capital stock, led to high productivity growth in the tradable goods sector. As expected, the external current account balance shifted into deficit in 1994 for the first time since independence. Even though export growth remained buoyant, imports rose sharply with the recovery in output and investment, while merchandise trade was reoriented toward western markets. Employment fell further in 1994, but was associated with a slight decline in the unemployment rate as the labor force shrank.

The recovery in output has been underpinned by sound macroeconomic policies. Monetary policy continued to be governed by the currency board arrangement, and fiscal policy remained tight. External trade and payments policies have been highly liberal. Regarding structural policies, there was a substantial acceleration in the sale of large state enterprises in 1994. By end-1994, virtually the entire stock of enterprises that could be disposed of without further restructuring and about 15 percent of all registered dwellings had been privatized.

II. Real Sector Developments

1. Output and expenditures

After a cumulative decline of almost 30 percent in 1992-93, real GDP is estimated to have increased in 1994. 1/ The sharp deterioration of Estonia’s terms of trade--due mainly to higher prices of energy imports--and sectoral shifts directly related to systemic change from a planned economy to a market-based economy, led to a pronounced fall in real GDP by 22 percent in 1992. Although economic activity began to turn around in the second quarter of 1993, real GDP fell by an estimated 6 1/2 percent in 1993 on an annual average basis.

Preliminary estimates suggest that GDP grew by 6 percent in 1994, led by continued strong growth in exports and buoyant investment activity (Table 1). Domestic demand increased by 16 percent, with gross capital formation increasing sharply by some 40 percent. The share of gross capital formation in GDP reached 31 percent in 1994, compared with 27 percent in 1992-93. Gross fixed investment, supported by sizable foreign direct investment inflows, strengthened markedly in 1994. Private consumption which had declined cumulatively by over 50 percent in 1992-93, increased by 5 percent in 1994, in line with rising real incomes. Real net exports made a negative contribution to growth amounting to over 10 percentage points. Exports of goods and nonfactor services rose by 25 percent in real terms in 1994 after growth of close to 40 percent in 1993. However, imports also increased markedly, in line with the surge in investment.

Table 1.Estonia: Gross Domestic Product By Expenditure
199219931994 1/
(Real change from previous year, percent)
Domestic demand–31.5–1.215.7
Private consumption 2/–41.1–7.45.4
Public consumption13.014.210.0
Gross capital formation–34.12.342.0
Gross fixed investment–34.116.746.0
Change in stocks 3/2.9–3.00.1
Net exports 3/6.8–7.8–10.5
Exports of goods and nonfactor services0.438.725.7
Imports of goods and nonfactor services–23.650.937.9
GDP at market prices–21.6–6.66.0
Sources: State Statistical Office of Estonia; and staff estimates.

Preliminary estimate.

Including consumption of non–profit institutions serving households.

Contribution to GDP growth.

Sources: State Statistical Office of Estonia; and staff estimates.

Preliminary estimate.

Including consumption of non–profit institutions serving households.

Contribution to GDP growth.

2. Sectoral developments

Data on the composition of GDP by sector reflect the continuing adjustment of Estonia’s economy to fundamental systemic change and the institutional disruption of former production and trade patterns. The importance of the services sector has risen substantially, and is now estimated to account for over 60 percent of GDP. Industry’s share in GDP has declined from over 40 percent in 1991 to less than 25 percent in 1994 and agriculture’s share from almost 20 percent to around 10 percent (Table 2).

Table 2.Estonia: Gross Domestic Product By Origin(Percentage shares)
1991199219931994 1/
Agriculture, hunting and forestry17.512.810.49.8
Fishing2.20.70.70.7
Mining and quarrying1.92.51.92.0
Manufacturing38.222.719.019.0
Electricity, gas and water supply2.04.43.53.0
Services38.156.964.565.6
Construction7.14.96.65.5
Wholesale and retail trade, repair of motor vehicles and personal and household goods8.514.517.019.5
Hotels and restaurants0.91.71.81.8
Transport, storage and communications7.214.012.411.3
Financial intermediation0.92.42.83.5
Real estate, renting and business activities1.96.46.85.4
Public administration and defence; compulsory social security1.92.33.44.0
Education2.83.95.76.5
Health and social work1.81.62.62.8
Other community, social and personal service activities5.05.15.45.3
GDP at factor cost100.0100.0100.0100.0
Source: State Statistical Office of Estonia.

Staff estimates.

Source: State Statistical Office of Estonia.

Staff estimates.

a. Industry

From 1992 to 1994, industrial output is estimated to have declined cumulatively by over 60 percent. This contraction has been associated with a host of factors: (i) the disruption of trade within the region and the loss of traditional markets, (ii) terms-of-trade shocks, (iii) the imposition of trade barriers by Russia, and (iv) competition from imports. The responses to these challenges have been varied, with some sectors successfully reorienting their trade and developing new markets, while other sectors have not been able to complete necessary structural adjustments. However, with substantial foreign direct investment inflows, foundations have been laid for a recovery in a number of the latter as well.

Sectors have been affected by the above factors to a varying degree. Adjustment has been slow in the food processing, chemical, machinery and equipment, and energy industries. Food processing, constituting 35 percent of industrial output, has continued to suffer output declines through 1994 due to the loss of traditional markets. The low quality of products and limited marketing skills have made it difficult to develop new markets or even hold on to domestic market share against competition from higher quality imports, in particular from Finland. The industry seems to have regained some of its traditional market in the St. Petersburg area, even after Russia erected new trade barriers in mid-1994. 1/ The chemical industry also has had problems reorienting itself toward western markets following the loss of traditional markets, due to the highly competitive nature of the consumer goods market and the lack of marketing skills and advertising expertise required for successful product placement. The disappearance of demand, in particular from the defense sector, has severely depressed the machinery and electronics industry. The reorientation from mass production to niche manufacturing has led to substantial excess capacity. After a large decline in production through 1993, output has been flat in 1994. Finally, the decline in industrial production and the reorientation to less energy intensive production processes has depressed demand for energy. Electricity production has increased slightly in 1994 after falling by 50 percent from 1991-93, oil shale output has continued to decline.

Low product quality has been the source of the collapse of several industries. In particular, the textile industry has become virtually uncompetitive and production has declined by over 60 percent from pre-reform levels. Major terms-of-trade shocks have led to the collapse of the pulp and paper industry. Despite a good resource base, energy inefficient production facilities could no longer produce pulp and paper competitively after energy prices had risen to world market levels in 1992.

Several industries have been more successful in their adjustment to the new conditions. With improvements in facilities and a low wage labor force, Estonia’s clothing industry has become very attractive for subcontracting. 1/ Manufacturers are also attempting to establish brand names of their own and develop markets in industrialized countries. The wood industry also is an example of successful reorientation of trade. In 1994, timber exports have increased by some 80 percent in volume terms and the industry is supported by high demand from domestic furniture manufacturers which appear to have gained entry to western markets.

b. Agriculture

Agriculture, as industry, has been subject to persistent difficulties associated with systemic change, such as terms-of-trade shocks and the loss of traditional markets. After stagnating already during the 1980s, agricultural output declined cumulatively by some 35 percent from 1990 to 1994, with a drop of 10 percent recorded in 1994.

Several factors played a large role in the severe decline of agricultural output. First, with the terms-of-trade shock in 1992, the rise in input prices was substantial. To restore the efficiency of production, less energy intensive technologies needed to be adopted and the old capital stock had to be replaced. Second, traditional markets collapsed and exports to Russia declined. While this development has partially been reversed by the real appreciation of the ruble toward end-1993, and exports to Russia recovered somewhat in the beginning of 1994, the effective doubling of Russian import tariffs in mid-1994 may have somewhat eroded the improvements in competitiveness. Third, the reorientation of trade to western markets has been slower than for the rest of the economy. Not only has it been hard to penetrate highly protected markets, but the quality of most processed agricultural products has not met Western European standards. Fourth, although the privatization of collective farms has proceeded quickly, the slow progress in land reform has hampered the efficient restructuring of agricultural production. 1/ Fifth, agricultural enterprises have experienced severe difficulties in obtaining bank credit due to overall limited long-term lending by commercial banks, and high risks associated with lending to the agricultural sector. The problem has been partially addressed by the establishment of the Agricultural Credit Fund, financed by budgetary allocations of the central government. However, funds made available through this facility have been modest and capital investments have been financed mainly through retained earnings.

c. Services

The services sector has been successful in its adjustment and is now developing rapidly. After initial declines in 1991-92, activity in transportation services has recovered. While road freight has continued to stagnate, maritime shipping and railway transportation have rebounded. Nevertheless, an aging capital stock and the lack of infrastructure may necessitate large capital investments to exploit Estonia’s comparative advantage as location for transit between Western Europe and Russia. Construction services adjusted relatively quickly to the fall in domestic demand by providing subcontracting work abroad and capacity utilization has already reached almost 80 percent in 1993 and 1994. The sector has also benefitted from increasing investment demand in 1994. The upward trend in the wholesale and retail trade appears to have continued through 1994. Despite only modest growth in private consumption, retail trade was stimulated by catering to foreign tourists, especially from Finland.

3. Labor market

Employment declined in Estonia during the entire period of transition. Estimates suggest that employment fell by a cumulative 17 percent during 1992-94 (Table 3). Job losses were concentrated in manufacturing and agriculture, where output declines were most severe.

Table 3.Estonia: Employment(In 1000 persons, annual average)
199219931994 1/
Agriculture, hunting and forestry 2/92.749.840.9
Fishing14.68.74.8
Mining and quarrying14.713.411.5
Manufacturing158.0127.3115.3
Electricity, gas and water supply15.411.714.3
Construction37.633.232.1
Wholesale and retail trade, repair of motor vehicles and personal and household goods46.155.551.6
Hotels and restaurants11.711.010.2
Transport, storage and communications57.447.445.9
Financial intermediation5.05.25.8
Real estate, renting and business activities20.723.922.5
Public administration and defence; compulsory social security31.327.829.2
Education42.048.448.3
Health and social work33.233.131.9
Other community, social and personal service activities21.520.218.2
Self–employed, small farmers, and others145.8164.9182.4
Total employment747.6681.4665.0
Percentage change–6.4–8.9–2.4
Unemployment37.965.758.6
Labor force785.5747.1723.6
Percentage change–1.7–4.9–3.1
Memorandum item:
Unemployment rate4.88.88.1
Sources: State Statistical Office of Estonia, Ministry of Finance; and staff estimates.

Staff estimate.

Excludes small farms.

Sources: State Statistical Office of Estonia, Ministry of Finance; and staff estimates.

Staff estimate.

Excludes small farms.

Despite this substantial decline in employment, unemployment has not become a major problem. Unemployment, which was virtually unknown under the planned system, peaked in 1993 at almost 9 percent and decreased to 8 percent in 1994, remaining well below unemployment rates of most other Eastern and Central European countries. 1/ The relatively low unemployment rate given the shocks the Estonian economy has had to absorb reflects several factors. First, the size of the labor force also fell--by some 10 percent during 1992-94, owing to emigration to Russia, increased employment of Estonian citizens abroad--mainly in Finland and other European countries--and a fall in the labor force participation rate. In addition, a sharp decline in real wages has moderated the impact of the output decline on employment (Chart 1).

CHART 1ESTONIA AVERAGE MONTHLY WAGES

Source: Data provided by the Estonian authorities; and staff calculations.

At the same time, the low unemployment rate may also be an indication that the economy has not yet adjusted fully. Although privatization has proceeded quickly and enterprises have had to face hard budget constraints with an effective bankruptcy law, 2/ there are also some indications that the reallocation of labor has lagged. In particular, large state-owned enterprises under privatization seem to have stopped short of sufficiently adjusting their work force. First, unable to pay the required compensation under the law for dismissing workers, 3/ some larger companies appear to have opted instead, for running up wage arrears. Second, in order to avoid labor shedding, enterprises have been moving employees from full-time to part-time employment or have been sending employees on partly compensated leave. 4/ This has given employers ample opportunity to reduce their wage bill without dismissing workers on a permanent basis.

Labor mobility plays an essential part in the adjustment mechanism to external shocks in Estonia. Indeed, for 1992, it is estimated that as much as 25 percent of the labor force changed jobs. 1/2/ The authorities have been pursuing passive and active labor market policies. The emphasis in structuring benefits has been on creating incentives for active job search, the main pillar of the authorities’ active labor market strategies being the establishment of retraining programs. Eligibility for unemployment benefits requires (i) a person to have been employed for six of the last twelve months, (ii) the person’s willingness to participate in retraining courses, and (iii) the employment office to be unable to provide an employment offer within 30 days. The unemployment cash benefit amounts to only EEK 180, currently just one twelfth of the average wage or 40 percent of the minimum wage 3/ and is limited to a maximum of nine monthly payments. Given the low level of cash benefits and the tight eligibility rules, less than one fifth of the unemployed are receiving unemployment benefits. 4/

4. Prices

Price liberalization in Estonia started already in 1989 and was mostly completed in 1992. As a result, consumer prices rose by over 200 percent in 1991, and by almost 1,100 percent in 1992. Since then, inflation has fallen rapidly to around 90 percent in 1993 and less than 50 percent in 1994 (Table 4). During 1994, price increases of 42 percent when measured by the CPI exceeded increases in producer prices which rose by 33 percent (Chart 2).

CHART 2ESTONIA PRICES

Source: Data provided by the State Statistical Office of Estonia.

Table 4.Estonia: Prices
Consumer Price Index 1/Producer Price Index 1/
OverallGoods 2/Services 2/Index Percent change
Index Percent change
1994
January230.75.5212.6307.2206.43.1
February242.75.2222.3326.5216.64.9
March264.38.9234.1377.1225.64.2
April272.53.1235.8404.4227.91.0
May275.51.1234.8418.5231.71.7
June277.50.7235.7423.2234.71.3
July285.22.8235.9452.5236.20.6
August288.11.0235.8463.7241.12.1
September297.33.2239.9488.2256.76.5
October300.61.1242.4494.3260.81.6
November305.41.6246.5501.2261.302
December309.71.4251.3505.2265.81.7
1995
January320.53.5258.6526.4287.98.3
February329.82.9266.3541.1292.81.7
Memorandum items:(Percentage changes)
Year–on–Year
19921,069.31,004.01,785.01,407.5
199389.079.0136.075.1
199447.731.682.536.3
Dec–to–Dec.
1992942.2851.02,167.01,125.4
199335.728.859.837.0
199441.622.878.032.8
Source: State Statistical Office of Estonia.

All indices are based on 1992=100.

Goods have a 67 percent and services a 33 percent weight in the overall CPI.

Source: State Statistical Office of Estonia.

All indices are based on 1992=100.

Goods have a 67 percent and services a 33 percent weight in the overall CPI.

The main factor responsible for the divergence of price indices during 1994 was increases in administered prices, which added significantly to increases in the consumer price index. 5/6/ In particular, the administered prices of services increased by 140 percent throughout the year. This relatively substantial rise reflected the fact that both the removal of subsidies and the shift toward pricing that incorporated the replacement cost of capital had been delayed following price liberalization.

As in previous years, the price index for services displayed a higher rate of increase than that for food and industrial goods. During 1994, prices of all services increased by 78 percent, and prices of services excluding those for which prices are raised administratively, increased by 33 percent. As rising incomes and large foreign direct investment inflows buoyed domestic demand, and as productivity increased relatively slowly in the services sector, prices increased at a higher rate than in the tradable goods sector.

The price increases for the goods component of the CPI moderated from almost 30 percent during 1993 to 23 percent during 1994. Moreover, there was a sharp slowing over the course of the year. After increasing by almost 15 percent during the first quarter, the rate of price increase of the goods component fell markedly, and registered only seven percent over the course of the remaining nine months of the year. Apart from seasonal factors, the steep real appreciation of the Russian ruble during the second half of 1993 may have reversed the previous deterioration in the terms-of-trade with Russia. 1/ Increased demand and the ability to raise prices in the Russian market resulted in a diversion of production from the domestic market to the external market and led to higher domestic prices of these tradable goods. 2/ In addition, the improvements in the terms-of-trade and increases in real income strengthened domestic demand for these goods.

5. Wages

Although half of the work force is organized, the influence of trade unions and employer organizations on wage setting remains limited. This allows enterprises to freely determine their wages based on firm-specific productivity developments; it also allows for job-specific wage differentiation. With the exception of the minimum wage, wages have been set on a decentralized basis since Estonia’s departure from central planning in 1990.

In 1994, the average wage increased by some 50 percent from its 1993 level. Following a sharp decline of almost 40 percent in 1992, the real consumption wage rose by 6 percent in 1993 and 4 1/2 percent in 1994 (Chart 1). The U.S. dollar wage rose from US$95 in December 1993 to US$175 in December 1994 (Chart 1), and is rapidly approaching those in other Central and Eastern European countries where, at end-December 1994, wages ranged from US$200 to US$400.

The minimum wage, which had been held at EEK 300 per month since 1992, was raised to EEK 450 on September 1, 1994. 1/ Despite this increase, the minimum wage did not keep pace with average wage developments, declining from one third of the average wage in 1992 to one fifth at end-1994.

6. Structural reforms

The program of price liberalization and institutional change which began in 1991 resulted in significant early progress toward a market economy. While delays in restitution and privatization slowed this process in late 1992 and 1993, the passage of the Law on Privatization in mid-1993 provided the foundation for a rapid acceleration in the privatization of state property during 1994 and early 1995.

a. Restitution

The Government is committed to restitute or compensate with vouchers all owners of property in Estonia prior to 1940 (including their descendants). To complete this process as quickly as possible and to minimize the uncertainties imposed by restitution on the privatization program, April 1, 1993 was set as a final deadline for filing restitution claims. As of that date, 210,300 claims were filed on 159,100 properties.

As of January 1, 1995, the validity of claims covering 70 percent of those properties had been resolved. However, property has actually been returned to legitimate owners, or vouchers issued in compensation for only about 10 percent or 15,000 properties. The restitution process is proving unexpectedly lengthy--especially the physical return of property--mainly because of significant modifications to some properties since 1940, problems that have arisen in agreeing on valuation where compensation has taken the form of vouchers or substitute property, and difficulties in registering land parcels in the absence of a formal land cadastre.

b. Privatization of enterprises

The privatization program in Estonia started in 1991 with the passage of the Law on the Privatization of State-Owned Trade and Service Enterprises, which provided the legal basis for the sale of small enterprises. By end-1994, virtually all such enterprises (mainly shops and service establishments)--about 1,500 in total--had been privatized, mainly through auctions. The privatization of large enterprises got off to a slower start with only seven large enterprises privatized by mid-1993. However, with the passage of the Law on Privatization, the sale of large enterprises accelerated quickly. Under the Law, the Estonian Privatization Office (EPO) was established to encourage the participation of foreign investors in the privatization process. The EPO is based on the German Treuhand model and has emphasized the sale of enterprises to owners with viable business plans that can offer both management skills and new capital. Employment and investment guarantees also play an important role in the evaluation of rival bids. 1/

The most visible element of the large-scale privatization program has been the nine international tenders (the last was announced on December 15, 1994) under which 266 enterprises have been sold for about US$135 million through February 8, 1995 (most have been sold for cash rather than against privatization vouchers). This set of enterprises represents virtually the entire stock of enterprises that can be sold without further restructuring.

The Law on Privatization permits a degree of flexibility in privatization methods. Accordingly, the EPO started in mid-1994 reserving a minority interest in several enterprises for sale against privatization vouchers. In these cases, the majority interest is normally sold in advance to a “core investor” that is responsible for providing management skills and capital. The first such sale--of the largest department store in Tallinn--was concluded in early March 1995 and involved a substantial oversubscription of offered shares. In addition, the EPO began work with the European Bank for Reconstruction and Development in 1994 to help in the privatization of several large enterprises where it was judged advantageous to complete a financial review, combined with restructuring if necessary, in advance of privatization.

c. Privatization of housing

The privatization of housing began in November 1993, when the necessary legislation became operational. Most housing is expected to be privatized against privatization vouchers. To complete this process as early as possible, the Government established a deadline of December 1, 1994 for registering the intent of occupants to privatize their apartments; this was later extended to March 1, 1995 to allow for wider participation. The deadline for completing owner-occupied residential purchases is December 1, 1995. Following that date, the Government’s intention is to auction off all unprivatized dwellings on a “best price” basis, in the first instance against privatization vouchers. By end-1994 about 15 percent of the nearly 375,000 dwellings in state ownership had been privatized.

d. Privatization vouchers and the securities market

Two types of privatization vouchers are being issued to the public: those to compensate owners of property prior to 1940 (restitution vouchers) and those based on the number of years employed in Estonia (national capital vouchers). The two forms of vouchers can be used interchangeably. The distribution of vouchers began in late 1993 and it is estimated that vouchers with a face value in the range of about EEK 15-18 billion, equivalent to about twice broad money at end-1994, will have been issued when the program is completed. Initially vouchers were issued in bearer form, but in May 1994 a special registry was established with the cooperation of several commercial banks that permitted vouchers to be held in special bank accounts.

Vouchers can be used for the privatization of housing and land or for the purchase of shares of state enterprises or of special funds, including those of the Compensation Fund. The Compensation Fund was established in 1993 as a vehicle for the transfer of the proceeds of privatization to voucher holders; it receives 50 percent of all privatization proceeds and holds most of its assets--which amounted to about EEK 300 million at end 1994--in domestic bank deposits. Bonds backed by its assets are issued periodically in exchange for vouchers. The first such offering was made in September 1994 when bonds with a face value of EEK 11 million were issued.

Limited trading of vouchers was introduced (mainly for pensioners) in May 1994 and such trading was fully liberalized for Estonian residents in August 1994. 1/ Shortly thereafter, and mainly due to a lack of investment opportunities, the price of vouchers fell to about 20-25 percent of face value, where it has remained through February 1995. In an effort to support the price of vouchers, the Government widened the range of assets that could be acquired against vouchers. The most important modification was to allow since mid-1994 resident buyers to use vouchers (valued at face value) for up to 50 percent of the purchase price of large enterprises sold at tender, but so far this measure has had little impact on the voucher price.

A computerized securities depository with the capability to support a full range of over-the-counter security trading operations was opened in September 1994. This depository is the principal trading mechanism for the roughly EEK 1 billion of securities (current market value), mainly investment funds and enterprise and bank shares, that have been issued in Estonia since 1992.

III. Fiscal Developments

Since independence in 1991, Estonia has pursued a prudent fiscal policy underpinned by the formal adoption of the concept of balanced budgets at the level of the central government. 1/ While the tax system underwent major reform during 1992 and 1993 with the aim of bolstering revenue, the Estonian authorities limited expenditure to available revenue and abstained from domestic financing of fiscal operations. Consequently, general government has recorded a financial surplus in each year since 1991 (Table 5). 2/ Foreign financing (mainly from the World Bank, the EBRD, and EU/G-24 countries) has been used primarily for critical imports to rehabilitate the economy and for investment projects which will facilitate economic growth.

Table 5.Estonia: Summary of General Government Fiscal Operations
1991 1/1992 1/199319941995
ProvisionalBudget
(In millions of EEK)
Total revenue6674,2518,60312,04315,952
Tax revenue6193,9278,17311,52315,571
Direct taxes4002,7475,4977,24910,174
VAT1089011,9943,2904,310
Excises73182403608771
Taxes on international trade377411919140
Other taxes123161185275
Nontax revenue 2/48324430520381
Total expenditure5824,1448,30111,73115,498
Current expenditure5203,9687,76411,27314,691
Expenditure on goods and services2842,7224,8107,5309,722
Current transfers and subsidies2361,2462,6103,2644,814
Other current expenditure 3/– –– –344478154
Capital expenditure 4/62176537458808
Financial surplus (+) / deficit (–)85107302312453
Net lending (–)– ––138–463–319–414
Borrowing requirement–85311617–40
Domestic financing–85–152–601–412–1,343
Foreign financing– –1837634191,303
(In percent of GDP)
Total revenue41.033.339.934.935.2
Tax revenue38.130.837.933.434.3
Direct taxes24.621.525.521.022.4
VAT6.67.19.29.59.5
Excises4.51.41.91.81.7
Taxes on international trade2.30.60.60.60.1
Other taxes0.10.20.70.50.6
Nontax revenue3.02.52.01.50.8
Total expenditure35.832.538.534.034.2
Current expenditure32.031.136.032.732.4
Expenditure on goods and services17.521.422.321.821.4
Current transfers and subsidies14.59.812.19.510.6
Other current expenditure 3/– –– –1.61.40.3
Capital expenditure 4/3.81.42.51.31.8
Financial surplus (+) / deficit (–)5.20.81.40.91.0
Net lending (–)– ––1.1–2.1–0.9–0.9
Borrowing requirement–5.20.20.7– ––0.1
Domestic financing–5.2–1.2–2.8–1.2–3.0
Foreign financing– –1.43.51.22.9
Sources: Data provided by the Estonian authorities; and staff estimates.

Data for 1991 and for the first half of 1992 have been converted at the exchange rate ruble 10=EEK1.

Privatization revenues do not accrue to the state budget but to separate extrabudgetary funds, and the use of these revenues is limited to expenditure in connection with the privatization process. Data for these operations are not included in the fiscal accounts.

Includes unallocated expenditure, some portion of government operations which may be net lending from domestic budgetary resources, and foreign–financed current expenditure.

Includes capital expenditure from both budgetary and foreign–financed resources.

Sources: Data provided by the Estonian authorities; and staff estimates.

Data for 1991 and for the first half of 1992 have been converted at the exchange rate ruble 10=EEK1.

Privatization revenues do not accrue to the state budget but to separate extrabudgetary funds, and the use of these revenues is limited to expenditure in connection with the privatization process. Data for these operations are not included in the fiscal accounts.

Includes unallocated expenditure, some portion of government operations which may be net lending from domestic budgetary resources, and foreign–financed current expenditure.

Includes capital expenditure from both budgetary and foreign–financed resources.

1. Developments in 1994

The original budget for 1994 was drawn up on a balanced basis. It projected a decline in tax revenue of about 10 percentage points of GDP, as a new income tax law reduced and simplified tax rates and eliminated exemptions. 3/ On the expenditure side, the budget had projected that government sector wages would decline by 1/4 percent of GDP. Expenditure on pensions was targeted to decline 1 3/4 percent of GDP, while other transfers and subsidies would decline by 1 1/4 percent of GDP. However, to the extent that actual revenues exceeded budget forecasts, additional spending was expected to be approved in the context of supplementary budgets, as the budget had been based on conservative revenue forecasts.

Revenue performance was significantly better than budgeted--by over 5 percentage points of GDP by the end of the year--and two supplementary budgets were passed by Parliament effective June and October. Under these budgets, additional expenditure was allocated to pensions, income support, housing allowances, internal security, capital expenditure, and wage increases mainly for educational and customs workers. The allocation for unemployment benefits was again reduced in light of the favorable evolution of registered unemployment. Additional funds were also made available for use by local governments.

In 1994 as a whole, general government operations resulted in a financial surplus of about 1 percent of GDP, while net lending amounted to about 1 percent of GDP. As a result, there was overall fiscal balance in 1994, compared to a deficit of 3/4 percent of GDP in 1993, suggesting that the fiscal stance was mildly contractionary. Foreign financing was about 1 1/4 percent of GDP and mostly went toward net lending operations. The financial surplus facilitated a buildup of financial assets in the domestic banking system, equivalent to about 1 1/4 percent of GDP.

Even though in 1994 fiscal revenue was higher-than-budgeted, the ratio of revenue to GDP declined by 5 percentage points of GDP, to about 35 percent of GDP, reflecting a decline in direct taxes (Table 6). Personal income tax revenue declined by 1 1/4 percent of GDP, to just over 7 percent of GDP, as the share of wages in GDP declined and the effective tax rate declined from 20 1/2 percent to just over 18 percent. 1/ Although there had been no change in the statutory rate of social tax (33 percent), the fall in the share of wages led to a decline in social tax revenue by 1 1/2 percent of GDP, to 10 1/2 percent. Corporate income tax revenue declined by 1 3/4 percentage points of GDP, reflecting both lower profitability and the effect of the substantially lower statutory rate. The yield on VAT (most of which comes from imports) increased by 1/4 percent of GDP, to 9 1/2 percent of GDP, reflecting the higher value of imports and better tax administration through firmer application of the registration rules and more critical examination of VAT returns. Continued problems with land registration hampered the effectiveness of the land tax, which produced a negligible 1/4 percent of GDP in 1994--the first full year of collection--compared with a budget expectation of 3/4 percent of GDP. Collection of excise taxes continued to be hampered by smuggling and evasion and revenue from these taxes was broadly unchanged at about 1 3/4 percent of GDP. 2/ Nontax revenue declined by 1/2 percent of GDP--slightly less than budgeted--reflecting lower profit transfers from state enterprises (some of which had been privatized) and a decline in a range of miscellaneous revenues.

Table 6.Estonia: General Government Revenue
19911/19921/199319941995
ProvisionalBudget
(In millions of EEK)
Total revenue6674,2518,60312,04315,952
Tax revenue6193,9278,17311,52315,571
Income taxs2571,5772,8693,5175,085
Corporate income1377201,0381,0381,170
Personal income1208571,8322,4793,915
Social tax1431,1702,6003,6355,050
Social Insurance1437311,5142,1703,050
Medical Insurance– –4391,0861,4652,000
Land tax– –– –279740
Taxes on goods and services1811,0832,3963,8985,081
VAT1089011,9943,2904,310
Excises73182403608771
Taxes on international trade377411919140
Environmental taxes123808298
Other taxes and fees– –– –81102177
Nontax revenue 2/48324430520381
(In percent of GDP)
Total revenue41.033.339.934.935.2
Tax revenue38.130.837.933.434.3
Income taxes15.812.413.310.211.2
Corporate income8.45.64.83.02.6
Personal income7.46.78.57.28.6
Social tax8.89.212.010.511.1
Social Insurance8.85.77.06.36.7
Medical Insurance– –3.45.04.24.4
Land tax– –– –0.10.30.1
Taxes on goods and services11.18.511.111.311.2
VAT6.67.19.29.59.5
Excises4.51.41.91.81.7
Taxes on international trade2.30.60.60.60.1
Environmental taxes0.10.20.40.20.2
Other taxes and fees– –– –0.40.30.4
Nontax revenue 2/3.02.52.01.50.8
Sources: Data provided by Estonian authorities; and staff estimates.

Data for 1991 and the first half of 1992 have been converted at the exchange rate ruble 10 = EEK 1.

Privatization revenues do not accrue to the state budget but to separate extrabudgetary funds, and the use of these revenues is limited to expenditure in connection with the privatization process. Data for these operations are not included in the fiscal accounts.

Sources: Data provided by Estonian authorities; and staff estimates.

Data for 1991 and the first half of 1992 have been converted at the exchange rate ruble 10 = EEK 1.

Privatization revenues do not accrue to the state budget but to separate extrabudgetary funds, and the use of these revenues is limited to expenditure in connection with the privatization process. Data for these operations are not included in the fiscal accounts.

Consistent with the cash-rationing policy, general government expenditure declined by 4 1/2 percentage points of GDP in 1994, to 34 percent of GDP (Table 7). 1/ Expenditure on wages increased steadily to reach 8 percent of GDP for the year as a whole, as the Government sought to limit the erosion of government sector wages. Excluding social programs, the bulk of government expenditure in 1994 was directed toward education and culture, expenditure on which was broadly unchanged at the equivalent of 4 percent of GDP. The Government gave higher priority to national security and expenditure on public order and internal security increased by 1/2 percentage point of GDP, to 2 3/4 percent of GDP, while expenditure on defence was broadly unchanged at nearly 1 percent of GDP. The Government did not adjust social benefits to keep pace with inflation, and transfers to households (primarily pensions, but also family and sickness benefits), declined by 1 1/2 percent of GDP, to 9 percent of GDP. Subsidies to enterprises were virtually eliminated and are essentially limited to covering a small proportion of the operating costs of public transport, mainly urban and interurban bus services. Such subsidies declined to 1/2 percent of GDP, from nearly 1 percent in 1993.

Table 7.Estonia: General Government Expenditure
1991 1/1992 1/199319941995
ProvisionalBudget
(In millions of EEK)
Total expenditure and net lending5824,2828,76512,05015,912
Total expenditure5824,1448,30111,73115,498
Current expenditure5203,9687,76411,27314,691
Expenditure on goods and services2842,7224,8107,5309,722
Wages and salaries749561,5862,7913,791
other purchases of goods and services2101,7663,2244,7395,931
Subsidies and current transfers2361,2462,6103,2644,814
Subsidies46223328163190
Transport102197157190
Heating119– –– –
Other subsidies 2/121136– –
Transfers to households1901,0232,2813,1014,625
Pensions486761,4401,9313,024
Family benefits6267479639771
Sickness benefits1245156206335
Unemployment benefits1050560
Housing allowance12425125243300
Income maintenance– –– –– –3870
Other– –– –314065
Other current expenditure 3/– –– –344478154
Capital expenditure 4/62176537458808
Net lending– –138463319414
Memorandum:
Military expenditure59174311417
(In percent of GDP)
Total expenditure and net lending35.833.640.634.935.1
Total expenditure35.832.538.534.034.2
Current expenditure32.031.136.032.732.4
Expenditure on goods and services17.521.422.321.821.4
Wages and salaries4.57.57.38.18.4
other purchases of goods and services13.013.914.913.713.1
Subsidies and current transfers14.59.812.19.510.6
Subsidies2.81.71.50.50.4
Transport0.80.90.50.4
Heating0.6– –– –
Other subsidies 2/0.90.1– –– –
Transfers to households11.78.010.69.010.2
Pensions3.05.36.75.66.7
Family benefits0.42.12.21.91.7
Sickness benefits0.70.40.70.60.7
Unemployment0.10.2– –0.1
Housing allowance7.60.20.60.70.7
Income maintenance– –– –– –0.102
Other– –– –0.10.10.1
Other current expenditure 3/– –– –1.61.40.3
Capital expenditure 4/3.81.42.51.31.8
Net lending– –1.12.10.90.9
Memorandum:
Military expenditure0.50.80.90.9
Sources: Data provided by Estonian authorities; and staff estimates.

Data for 1991 and the first half of 1992 have been converted at the exchange rate of ruble 10 = EEK 1.

Includes heating subsidies for 1992.

Includes unallocated expenditure, some portion of government operations which may be net lending from domestic budgetary resources, and foreign–financed current expenditure.

Includes capital expenditure from both budgetary and foreign–financed resources.

Sources: Data provided by Estonian authorities; and staff estimates.

Data for 1991 and the first half of 1992 have been converted at the exchange rate of ruble 10 = EEK 1.

Includes heating subsidies for 1992.

Includes unallocated expenditure, some portion of government operations which may be net lending from domestic budgetary resources, and foreign–financed current expenditure.

Includes capital expenditure from both budgetary and foreign–financed resources.

Disbursements of foreign loans were substantially lower than expected, as a result of technical problems and delays in project implementation, and declined by 2 1/4 percent of GDP in 1994, to about 1 1/4 percent of GDP. Most of these loans continue to be provided by the World Bank, EBRD, and EU/G-24 countries to finance critical imports and for construction and repair in the energy and communication sectors mostly through government lending operations. About three-quarters of these loans were to the nongovernment nonbank sector and the remainder was used directly by local government.

2. The budget for 1995

For 1995, Parliament has approved a balanced budget for the operations of the central government, while the approved budgets for the main extrabudgetary funds (Social Insurance Fund and the Medical Insurance Fund) envisage small surpluses. Official projections for local government budgets indicate that their necessary expenditure will be more than covered by tax revenues and transfers from central government. For general government as a whole, therefore, official estimates indicate a financial surplus of about 1 percent of GDP. Net lending is projected to be equivalent to about 1 percent of GDP and will be financed from foreign sources. The Government expects a large increase in foreign financing, which will continue to be mainly World Bank, EBRD, and EU/G-24 loans to be used for infrastructure and energy sector development projects. The Government does not foresee a need for domestic financing in 1995. 1/ Indeed, a large build-up of domestic financial assets is projected. Based on these projections, indications are that there will again be overall fiscal balance in 1995, implying a broadly neutral fiscal stance.

No major changes in the structure and rates of taxes are envisaged in the budget. However, more vigorous tax administration is expected to lead to a substantial increase in revenue from personal income tax (by 1 1/2 percentage points of GDP), and some minor changes to the VAT law are envisaged to formalize the power to delay refunds. Tax revenue stamps on tobacco products became compulsory from January 1, 1995. Parliament will also consider legislation to amend customs duties and the excise tax on motor vehicles to relate it to the age and engine size of the vehicle, not its stated value.

There has been no change in the revenue-sharing arrangements between central and local government for personal income tax, with 52 percent accruing to local budgets and 48 percent going to the state budget. 2/ Land tax revenues were shared equally throughout 1994 as the national and local tax rates were each 0.5 percent. In 1995, while the national rate will remain at 0.5 percent, local rates will range from 0.3 percent to 0.7 percent. 3/ New laws on local taxes were enacted in late 1994 and give local governments power to levy, inter alia, local income tax on enterprises up to a rate of 2 percent and local sales tax up to a rate of 1 percent.

On the expenditure side, the Government’s policy in 1995 will be to reverse the decline of government sector wages and state pensions in real terms. Government sector wages are substantially below those in the private sector and declined to about 80 percent of the national average in 1994. The budget targets these wages to rise to about 90 percent of the national average, based on projections for average wages. Consequently, central government wages are budgeted to increase by 47 percent in 1995. 4/ Pensions are budgeted to rise substantially faster than inflation and expenditure on these would rise by just over 1 percentage point of GDP.

Although the Public Investment Program has not yet been approved by Parliament, the Government recognizes the need for increased public investment during 1995. Consequently, capital expenditure is budgeted to rise by 1/2 percentage point of GDP. Much of this expenditure will be on roads, communications, and repair and construction of educational buildings. The Government hopes that budgeted capital expenditure will be complemented by an equivalent amount of foreign-financed investment.

3. Social safety net

The Government’s intention during 1994 was to continue to strengthen and rationalize the social security system and to ensure that aid was effectively channeled to the most vulnerable groups of the population, while taking account of budgetary constraints. Pension reform had been undertaken in 1993 and the heating support program had been amended in 1992 and 1993. The original budget for 1994 had projected that transfers to households would decline by 2 percentage points of GDP; however, these transfers only declined by 1 1/2 percent of GDP following the allocation of additional funds in the supplementary budgets.

During 1994, expenditure on pensions declined by about 1 percentage point of GDP, although originally budgeted to decline by about 1 3/4 percentage points. Costs were contained by raising the retirement ages with effect from January 1, 1994. 1/ In addition, the increase in the “public” pension was considerably less than inflation, 2/ and the average pension declined from about 35 percent of the average wage in 1993 to 30 percent of the average wage in 1994. The public pension was increased by 20 percent in November 1994, but no further increase in pension levels is envisaged in the budget. 3/ Even though the 1995 budget allocates an additional 1 percent of GDP for pensions, the average pension in 1995 is likely to decline further relative to the average wage. The State pension system is expected to remain in balance in 1995. Its main source of funding is part of the social tax, which provided the Social Insurance Fund with revenue of over EEK 2 billion (6 1/4 percent of GDP) in 1994 and is projected to produce revenue of just over EEK 3 billion (6 3/4 percent of GDP) in 1995, as wages increase in real terms and employment levels remain stable. 1/

The structure of the family and child benefits program was unchanged during 1994 and its coverage is still universal. 2/ Payments under this program are fully covered by transfers from the State budget to the Social Insurance Fund. Expenditure on this program declined broadly in line with budget projections, by about 1/4 percent of GDP in 1994, to about 2 percent of GDP. This decline was despite an increase of about 20,000 in the number of recipients, and an increase in the range of the main benefits from EEK 90-180 per child to EEK 105-210 in the second supplementary budget. The budget for 1995 envisages that expenditure under this program will be equivalent to about 1 3/4 percent of GDP. No change in the level of benefits is envisaged and the number of recipients of child allowances will increase by about 16,000. 3/

The housing allowance program was unchanged during 1994, with the Government reimbursing expenditure that exceeds 30 percent of a household’s gross income. In 1994, transfers to households for this purpose were broadly unchanged, at 3/4 percent of GDP, as originally budgeted. An equivalent amount is included in the 1995 budget, assuming there will be about 112,000 recipients (an increase of about 7,000).

Unemployment compensation has remained low--and in 1994 was a negligible part of government expenditure. Average unemployment declined during the year and initial budget appropriations for compensation for 1994 were curtailed in the supplementary budgets.

Although a new program of income support was implemented in 1994 which guaranteed a minimum income to all Estonian households, expenditure on this program was insignificant during 1994 and will remain so in 1995.

IV. Money and Credit

1. Overall developments

Under Estonia’s currency board arrangement, changes in reserve money correspond to the balance on the current and capital account transactions, as the Bank of Estonia matches currency issue and kroon deposit liabilities by net foreign assets. The Bank of Estonia does not lend to the local or central governments, and lending to commercial banks is restricted to emergency situations and limited by the need to maintain full cover for currency board liabilities. 1/

After strong real growth in the latter part of 1993, broad money increased by 30 percent in 1994, thus falling by about 8 percent relative to consumer price inflation (Chart 3). Except for a decline in April which may have been the result of seasonal factors, (nominal) broad money increased steadily throughout the year. The decline in the annual growth rate of base money was even sharper, falling from 106 percent in 1993 to 11 percent in 1994, with almost all of the increase in base money occurring in the last quarter of the year (Table 8). Developments in base money were influenced by the sharp reduction in commercial bank excess reserve levels from 21 percent to 9 percent of their deposits by the end of the year. Base money was also temporarily affected by the Bank of Estonia lending to the Social Bank in the third quarter of 1994.

CHART 3ESTONIA MONETARY AGGREGATES

(Billions of kroons)

Source: Data provided by the Bank of Estonia.

1/ Including net claims on General Government.

Table 8.Estonia: Monetary Authorities 1/(In millions of EEK)
199219931994
IIIIIIIV
Net foreign assets2,911.04,460.54,436.54,406.54,381.94,546.6
Foreign Assets3,596.75,409.15,456.75,408.65,334.65,540.6
Currency board cover1,809.13,877.53,885.33,886.63,953.44,318.8
Foreign liabilities685.7948.61,020.11,002.1952.6994.1
Net domestic assets–1,133.5–622.5–655.6–588.5–458.8–268.2
Net claims on Government–0.339.044.344.4–11.50.0
Claims on financial institutions492.8409.2264.1301.7393.4573.9
Claims on nonfinancial public ante– –63.5104.192.992.914.8
Claims on private sector– –4.64.75.56.58.2
Other–1,626.0–1,138.8–1,072.7–1,033.1–940.1–865.2
Base money1,862.73,837.83,780.73,817.83,922.94,277.2
Currency issue1,228.32,730.22,731.12,983.03,153.03,512.3
Deposits of commercial banks634.41,047.6989.6793.4709.9704.8
Certificate of deposit– –60.060.041.460.060.0
Source: Data provided by the Estonian authorities.

Comprises the Bank of Estonia and the External Financing Board.

Source: Data provided by the Estonian authorities.

Comprises the Bank of Estonia and the External Financing Board.

The Bank of Estonia lowered the effective reserve requirement on deposits with commercial banks in July 1994 by allowing vault cash to be used for up to one half of the reserve requirement. As commercial banks had been holding in excess of that amount as precautionary liquidity balances, this effectively reduced reserve requirements by about 5 percentage points. However, indications are that the rate of monetary expansion was largely unaffected by that reduction. Commercial bank data suggest that excess liquidity was used to fund an increase in bank deposits abroad, and not to expand domestic lending operations. Between end-June and end-December 1994, commercial bank foreign currency holdings rose by 87 percent, whereas lending to the private sector rose by only 15 percent. For the year as a whole, about two thirds of the increase in broad money was matched by a buildup of net foreign assets of the banking system. Net credit to the private sector doubled--an increase of about 20 percent in real terms (Table 9). However, the impact of the increase on net domestic assets of the banking system was partially offset by the expansion of net government deposits, and credit to state enterprises also declined.

Table 9.Estonia: Banking Survey
1992199319941994
IIIIIIIV
(In millions of kroons, end of period)
Net foreign assets4,394.15,692.26,923.25,380.95,686.76,415.06,923.2
Foreign assets5,182.56,839.98,561.36,658.57,053.67,822.78,561.3
Foreign liabilities788.41,147.61,638.01,277.61,367.01,407.71,638.0
Net domestic assets–541.4387.81,010.1886.6854.4602.41,010.1
Net domestic credit1,355.22,326.23,251.42,919.82,937.92,983.53,251.4
Claims on general government (net)–275.3–577.1–1,305.9–680.8–1,137.2–1,400.5–1,305.9
Claims on other fin. inst.0.08.712.24.121.816.912.2
Claims on state enterprises644.4480.1360.8476.5457.4463.3360.8
Claims on private sector986.12,414.54,184.33,120.03,595.93,903.84,184.3
Other items (net)–1,896.6–1,938.4–2,241.3–2,033.2–2,083.5–2,381.1–2,241.3
Broad money (M3)3,852.56,080.07,929.26,267.56,541.17,017.57,929.2
Currency outside banks1,040.72,380.63,071.32,422.72,656.32,829.43,071.3
Demand deposits1,679.42,847.43,248.62,791.12,721.72,912.43,248.6
Time and savings deposits248.4572.3684.3653.5646.7708.3684.3
Foreign currency deposits884.0279.7925.0400.2516.3567.3925.0
(Percentage change relative to previous period broad money)
Net foreign assets100.633.720.2–5.14.911.17.2
Net domestic assets–32.624.110.28.2–0.5–3.95.8
Net domestic credit10.725.215.29.80.30.73.8
Of which:
Claims on state enterprises–9.1–0.0–2.0–0.1–0.30.1–1.5
Claims on private sector28.037.129.111.67.64.74.0
Broad money (M3)68.057.830.43.14.47.313.0
(As ratios)
Memorandum item
Base money multiplier2.31.61.81.61.71.81.8
Sources: Data provided by the Estonian authorities; and staff estimates
Sources: Data provided by the Estonian authorities; and staff estimates

Reflecting the decline in commercial bank excess reserves, the money multiplier rose from 1.6 to 1.8 during 1994 (Chart 4). The currency to deposit ratio remained fairly constant at about 65 percent throughout the year, suggesting that the public’s confidence in the banking system did not change during the year despite the problems associated with the troubled Social Bank (see below). 1/

CHART 4ESTONIA BASE MONEY MULTIPLIER

Source: Data provided by the Bank of Estonia.

Currency board cover remained well above 100 percent of cash and reserve liabilities. Despite robust foreign direct investment in Estonia and booming exports, rumors of kroon devaluation emerged several times during 1994, initially in response to the sharp increase in monthly inflation in the first quarter of 1994. With a view to maintaining confidence, the Bank of Estonia started offering forward foreign exchange contracts with maturities ranging from two days to seven years in April, at the pegged rate of EEK 8 per deutsche mark. 2/ The Bank of Estonia subsequently limited the sale of forward contracts to domestic banks, and to three quarters of a domestic commercial bank’s assets (less loans from other banks) over the preceding six-month period in December 1994; while a few banks purchased contracts up to the allowed limit, the amount of contracts outstanding was about one quarter of the permitted total amount for the banking system by the end of the first quarter of 1995. Devaluation concerns re-emerged in late 1994, and may have led to an increase in the ratio of foreign deposits in broad money in December. As a result, together with the effect of the removal of foreign exchange restrictions in May which allowed residents to hold accounts in foreign currencies with the domestic banking system, foreign currency deposits with the banking system rose by 220 percent during the year, and accounted for about 12 percent of broad money by year-end.

2. Commercial banking

In general, commercial banks improved their operations in 1994. However, overall profitability of the commercial banking system suffered in 1994, partly as increased competition among banks lowered profits from foreign exchange operations. Interest thus became the largest source of revenue for banks, and many banks used profits to bolster their capital position in preparation for the pending increase in capital requirements (see below). There was little change in the structure of the financial system during the year, and there was no change in the number of banks.

Unlike the banking crisis of 1992, when a commercial bank was allowed to fail with losses to depositors, the Bank of Estonia lent the equivalent of about 6 percent of base money to the troubled Social Bank, in August/September 1994 to meet large withdrawals. Problems at the Social Bank surfaced in February/March 1994, when the rapid withdrawal of government deposits from the bank revealed substantial loan losses and poor management. Liquidity problems became acute in early August with further withdrawals of deposits, and the Bank of Estonia suspended the Social Bank’s operations in mid-August, pending the implementation of plans to liquidate it. 1/ On September 26, 1994, however, the Bank of Estonia reversed its position and reopened the bank, and provided it with liquidity support to meet a possible further withdrawal of deposits. The Bank’s shift in position was attributed to concerns about the effect of a bank failure on confidence in the banking system, expectations that a higher portion of the Social Bank’s loans would be recoverable if the bank stayed in operation, the prospects that formal bankruptcy would involve a long, drawn-out process, and the possibility of lawsuits from remaining depositors which could unwind the earlier sale of some of the Social Bank’s branches.

Following its reopening, the Social Bank faced withdrawals of over one-half of its deposits and other short-term liabilities, including by government agencies. Additional Bank of Estonia liquidity support was to allow the bank to stay afloat. During August and September, the Bank of Estonia lent the Social Bank EEK 231 million. Additional withdrawals of deposits from the bank were met by borrowing from other domestic banks, using the bank’s fixed assets and better-quality loans as collateral. Furthermore, in October, the Bank of Estonia merged the Social Bank with another insolvent bank, the Development Bank, at which time it also implicitly assured the private depositors of the merged bank that they would not suffer any losses. The situation of the merged bank deteriorated further, as it faced a negative cash flow. While its clients were not actively withdrawing deposits, additional deposits in the bank did not cover expenses and periodic withdrawals (for wage payments, for example).

The Bank of Estonia (with the concurrence of the Government) concluded agreements to sell parts of the Social Bank in March 1995, and started work on converting the remainder to a loan recovery agency. All depositor accounts were transferred to other banks, some with the sale of the branches at which the accounts were held. The transfer of accounts and some branches to the North Estonian Bank involved the subordination of some of the Government’s and the Bank of Estonia’s deposits.

3. Interest rates

Given the kroon peg to the deutsche mark, interest rates in Estonia are tied to German rates and the Bank of Estonia’s certificate of deposit interest rate has generally tracked the deutsche mark interbank market rate since the introduction of certificates of deposit in May 1993. 1/ The Bank of Estonia’s certificate of deposit rate was slightly below the German interbank rate between May 1993 and May 1994, and exceeded German rates during the rest of the year (Chart 5). The difference between the rates peaked in mid-1994, with the certificate of deposit rate exceeding the German interbank rate by more than 1 percentage point in June and July. The differences between the two rates may in part reflect divergent domestic conditions, as capital is less than perfectly mobile between the two markets. Part of the difference between the two rates may also be attributed to the fact that the Estonian certificate of deposit rates are not necessarily for the end of the month but for the date of the latest auction prior to the end of the month. 2/ It is not likely that differences between the two rates on these short-term instruments (with 28-day maturities) were due to expectations that the exchange rate would be changed, as the exchange rate in Estonia can be changed only through an act of Parliament, which could be a relatively time-consuming process.

CHART 5ESTONIA INTEREST RATES

(Percent per annum)

Sources: Data provided by the Bank of Estonia; and IMF, International Financial Statistics.

The structure of interest rates in Estonia is characterized by large margins. Despite steep declines in 1993 and early 1994, the margin between deposit and lending rates remained fairly high at about 10-15 percentage points during 1994 (Table 10). This margin partly reflected the maturity mismatch between commercial bank assets and liabilities, as commercial banks may have opted to hold additional precautionary reserves to meet possible withdrawals of demand deposits, which represent the bulk of their liabilities. Given that commercial bank lending rates were about 10 percentage points (per annum) higher than in Germany, the margin may also reflect the higher credit risks associated with Estonian borrowers, partly owing to the lack of suitable collateral. Long-term lending rates were about 5 percentage points lower than shorter maturities in part as commercial banks financed their long-term lending through external financial assistance at concessional rates.

Table 10.Estonia: Average Interest Rates, 1993–94(In percent per annum)
19931994
MarchJuneSeptemberDecemberMarchJuneSeptemberDecember
Deposit rates
Demand deposits3.42.82.72.62.72.72.72.7
Time deposits19.018.815.212.711.612.711.210.1
Lending rates
Loans up to 1 month46.932.636.431.427.831.828.526.7
Loans 1 to 3 months40.541.132.429.227.926.723.223.2
Loans 3 to 6 months41.933.628.530.423.921.222.525.2
Loans 6 to 12 months30.032.127.222.122.624.822.021.3
Loans 1 to 3 years33.318.321.821.918.219.917.719.1
Loans 3 to 5 years14.227.213.512.116.715.116.916.8
Loans over 5 years8.78.79.69.610.412.010.013.0
Money market rates
BOE CD auction rate7.46.36.15.56.35.85.4
Interbank overnight lending rate11.27.26.35.65.65.55.4
Source: Bank of Estonia.
Source: Bank of Estonia.

The margin between time- and demand-deposit rates also remained high at about 10 percentage points on average in 1994. The difference in rates compensates depositors for the risk of bank failures--indeed deposit rates exhibited a wide range among banks. Finally, owing to an increased risk premium charged by banks in their interbank lending operations with the Social Bank, the average interbank overnight interest rate in the Estonian market--which in the past had been lower than that in the German interbank market--exceeded the rate charged in the German interbank market by as much as 100 basis points in the Fall. However, while interbank lending rates to the Social Bank exceeded German rates, lending rates to other banks remained at rates comparable to those prevailing in the German interbank market.

4. Exchange rates

At the time of its introduction in mid-1992, the kroon was thought to be substantially undervalued, although the amount was not quantifiable because of the structural transformation which was under way. The real value of the kroon, measured on the basis of relative movements in consumer prices, rose sharply during June-December 1992, owing to lags in reducing domestic inflation from the very high rates experienced prior to currency reform, and also to depreciation of the Russian ruble. The real value of the kroon remained approximately constant during 1993, although there was a continuing appreciation of the kroon against western currencies of western trading partners which was offset by substantial real depreciation against the ruble. By end-1994, it was estimated that most tradable goods’ prices were close to world levels after the kroon had risen by 29 percent in real terms against western currencies.

Despite the real appreciation, Estonian tradable goods appeared to remain competitive in 1994. Export volumes grew by 35 percent in 1994, including nearly 50 percent to western countries relative to which the real appreciation has been strongest.. While imports have grown even faster, much of this expansion has been related to, and financed by, foreign direct investment--itself an indication of investor confidence in Estonia’s economic policies and low production costs. Although information on unit labor costs is not available, average wages during 1994 were US$131 per month, broadly within the range of other transforming economies.

5. Financial sector regulations

The Bank of Estonia is in the process of aligning financial regulations with those of the European Union (EU) by the year 2000. To that end, the Credit Institutions Act was approved by Parliament in December 1994, and became effective in January 1995. The Act is based on comparable legislation in EU countries. It sets, inter alia, targets for the capital requirement for banks to reach ECU 5 million by January 1, 2000. 1/ New prudential ratios, set at internationally acceptable levels, became effective as of March 1995. The solvency ratio has been set so that a bank’s capital is at least 8 percent of risk-weighted assets; large exposure regulations lowered maximal exposure to a single borrower froth 50 percent to 25 percent of share capital, and to 20 percent of share capital to a group of connected clients, and limit total large exposures to 800 percent of a credit institution’s own funds. Moreover, the minimum ratio of liquid assets relative to currency liabilities was set at 30 percent, and the open foreign currency position in any single currency was limited to 10 percent, with a sum of absolute open positions no greater than 30 percent (with the exception of deutsche mark assets). These regulations supplement regulations on asset classification standards, provisions for problem loans, and other asset concentration guidelines introduced earlier in the year. Moreover, a new Accounting Act, which is in broad conformity with internationally accepted accounting principles, became effective as of January 1, 1995.

To support the effective implementation of these regulations, the Bank of Estonia has been strengthening banking supervision. A short-term program for intensified bank supervision for 1995 has already been developed by the Bank of Estonia. It includes a sizable expansion in banking supervision personnel and their training. Moreover, commercial bank reporting forms have been amended to facilitate comprehensive on site monitoring. In 1994, the banking supervision department requested that 11 commercial banks (out of a total of 21) not pay dividends, that they use their earnings to bolster their capital positions especially given the prospective increase in capital requirements, and directed them to reduce their operating costs. The banking supervision department also required each commercial bank to develop a detailed plan which would enable it to meet the capital requirement for 1995 for potentially troublesome banks, and show how the financial viability could be restored.

Technical assistance to improve commercial bank operations is being provided by the Core Advisors Group, which is supported by EU/PHARE, and the Governments of Denmark and Sweden. This assistance focuses on the improvement of credit evaluation capabilities, the formulation of credit policies, internal methods and policies to better evaluate and manage credit risks, and training programs in risk management.

V. The Balance of Payments, External Debt, and Reserves

After registering surpluses in 1992 and the first part of 1993, Estonia’s current account swung into deficit in late 1993 and reached a deficit equivalent to 6 1/2 percent of GDP in 1994. The trade deficit more than doubled in 1993 and again in 1994, as imports increased owing to the surge in foreign direct investment, real appreciation of the kroon from its initial undervaluation and growing real incomes. Exports expanded rapidly in volume and value terms, reflecting Estonia’s increasing ability to compete in western markets. The reorientation toward trade with Western Europe that began in 1992, when the terms-of-trade shock and severe payments difficulties disrupted trade with countries of the former Soviet Union, continued through 1994. Net service receipts continued to partially offset the trade deficit in 1994.

On the capital account, foreign direct investment continued to dominate inflows, reflecting Estonia’s competitiveness and investors’ confidence in its economic policies. The amount of official lending fell in 1994 as disbursements on committed loans were delayed by technical problems. The rise in net international reserves slackened in 1994, in line with developments in reserve money demand, while gross reserves averaged 3.3 months of imports over the year. Official debt (including the use of Fund credit) remained very low at only US$173 million at end-1994, or 6 1/2 percent of GDP (Table 11).

Table 11.Estonia: Balance of Payments(In millions of U.S. dollars)
199219931994
Current Account82.811.5–171.1
Trade balance–62.7–156.7–345.3
CIS and Baltics–50.917.078.8
Other countries–11.8–173.7–424.1
Exports457.2811.51304.7
CIS and Baltics215.3341.4586.3
Other countries241.9470.1718.3
Imports–519.9–968.2–1650.0
CIS and Baltics–266.2–324.4–507.6
Other countries–253.7–643.9–1142.4
Nonfactor services52.877.0134.5
Transport59.898.8156.4
Tourism14.624.533.1
Other services 1/–21.6–46.3–55.0
Factor services–1.9–14.0–32.5
Interest1.016.419.2
Other–2.9–30.4–51.7
Transfers94.7105.271.9
Official 1/95.0105.666.7
Private–0.3–0.45.2
Capital account120.9145.5199.9
Foreign direct investment57.9160.4253.0
Other long term13.287.115.0
Public13.368.836.3
Private–0.218.4–21.3
Short term–34.0–56.8–84.3
Public13.4–15.7–2.9
Commercial banks–36.4–38.4–76.6
Other private–11.0–2.7–4.8
Bank of Estonia115.6–2.92.2
Correspondent accounts 2/–24.7–2.92.2
Claims on gold 3/140.2– –– –
Errors & omissions–31.8–42.314.0
Overall Balance203.7157.028.7
Net international reserves 4/–203.7–157.0–28.7
Memorandum items
Exchange rate (kroons/US$)11.713.213.0
Gross international reserves 5/195.2388.4447.0
(in months of goods imports)4.54.83.3
Use of Fund Credit (end of period)10.757.561.1
(Percent change)
Export volume42.534.9
CIS and Baltics–6.34.5
Other countries85.948.6
Import volume61.555.5
CIS and Baltics–19.45.3
Other countries146.372.8
(In Percent)
FDI/GDP6.59.89.5
Debt service/Exports G&NFS 6/3.21.70.5
Debt/GDP 6/4.28.66.5
Current account/GDP9.20.7–6.4
Sources: Estonian authorities; and staff estimates.

Includes technical assistance.

Assets and liabilities vis–a–vis the CIS and Baltics held in nonconvertible currencies as international reserves of the Bank of Estonia.

Restituted gold which had been held by central banks abroad on behalf of Estonia. These assets were included in international reserves at the time the restitution took place.

In convertible currency, including currency board cover (–increase).

End of period. Includes restituted gold, short–term claims in convertible currencies, and SDR holdings.

Includes IMF.

Sources: Estonian authorities; and staff estimates.

Includes technical assistance.

Assets and liabilities vis–a–vis the CIS and Baltics held in nonconvertible currencies as international reserves of the Bank of Estonia.

Restituted gold which had been held by central banks abroad on behalf of Estonia. These assets were included in international reserves at the time the restitution took place.

In convertible currency, including currency board cover (–increase).

End of period. Includes restituted gold, short–term claims in convertible currencies, and SDR holdings.

Includes IMF.

1. Merchandise trade

In 1990-91, Estonia’s trade was almost completely within the Soviet Union, which accounted for 95 percent of exports and 85 percent of imports (Table 12). 1/ Imports consisted largely of raw materials, particularly energy from Russia, and some intermediate goods, while exports were agricultural and timber products, processed food, light manufactures, and electricity produced from oil shale (Table 13). Russia’s share was roughly half of both imports and exports, while other nearby states accounted for most of the rest of trade. While Estonia had traditionally registered trade deficits, it began liberalizing prices in 1990, ahead of most other Soviet states, and enjoyed a modest terms-of-trade improvement which led to a trade surplus in 1991.

Table 12.Estonia: Directions of Trade
19921993199419901991199219931994
(In millions of EEK)(In percent of total)
Exports5,209.610,611.416,637.4100.0100.0100.0100.0100.0
Russia928.42,405.53,952.655.856.917.822.723.8
Finland1,269.12,278.43,278.61.22.324.421.519.7
Sweden471.81,003.91,809.60.40.59.19.510.9
Latvia540.0913.91,335.45.87.710.48.68.0
Germany225.3850.61,156.80.30.24.38.07.0
Lithuania69.2396.4906.63.23.81.33.75.4
Netherlands260.2432.2491.2– –0.35.04.13.0
Denmark124.3247.3538.6– –0.12.42.33.2
Ukraine297.7378.1467.213.312.95.73.62.8
United Kingdom61.2149.4407.8– –0.11.21.42.5
USA104.2197.1265.00.20.12.01.91.6
Belarus59.1120.6312.14.74.11.11.11.9
Others799.11,238.01,715.915.110.815.311.710.3
Memorandum items:
EFTA 1/1,813.83,455.45,371.71.83.034.832.632.3
CIS1,578.53,223.15,086.786.383.930.330.430.6
EU 2/696.41,875.92,963.60.51.213.417.717.8
Eastern Europe 3/772.21,543.52,419.810.713.014.814.514.5
Imports 4/5,130.311,920.921,189.9100.0100.0100.0100.0100.0
Finland1,509.33,974.87,901.51.62.029.433.337.3
Russia1,670.52,019.83,316.351.745.932.616.915.7
Sweden336.81,057.32,147.60.10.86.68.910.1
Germany389.11,123.11,861.92.30.87.69.48.8
Netherlands80.2382.3718.50.20.11.63.23.4
Denmark115.6312.0609.30.10.12.32.62.9
Lithuania88.1419.2585.83.26.31.73.52.8
Latvia72.2285.3416.94.75.11.42.42.0
USA161.8296.5388.40.93.53.22.51.8
United Kingdom67.1211.4323.71.10.11.31.81.5
Other639.61,839.22,920.034.035.212.515.413.8
Memorandum items:
EFTA 1/1,947.55,182.710,442.22.33.038.043.549.3
EU 2/688.22,537.64,386.94.13.013.421.320.7
CIS1,938.52,578.64,038.374.073.437.821.619.1
Eastern Europe 3/211.0848.11,193.110.413.24.17.15.6
Sources: Bank of Estonia; and Department of Statistics.

Austria, Finland, Norway, Iceland, Sweden, Switzerland.

Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, United Kingdom.

Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, and Slovak Republic.

Covers only identified imports.

Sources: Bank of Estonia; and Department of Statistics.

Austria, Finland, Norway, Iceland, Sweden, Switzerland.

Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, United Kingdom.

Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, and Slovak Republic.

Covers only identified imports.

Table 13.Estonia: Trade by Commodity
19921993199419901991199219931994
(In millions of EEK)(In percent of total)
Exports
Live animals, animal products533.11,112.21,169.67.410.110.210.56.7
Vegetable products48.9113.3291.71.00.90.91.11.7
Animal, vegetable fats and oils7.074.780.21.63.30.10.70.5
Food, drink and tobacco279.51,138.52,069.011.24.15.410.711.9
Mineral products584.1807.91,335.93.25.311.27.67.7
Chemicals331.1511.21,151.710.211.16.44.86.6
Plastics and related products72.3156.9319.74.14.81.41.51.8
Hide, skins and leather97.1184.5218.31.40.61.91.71.3
Wood and wood products450.2791.01,627.01.02.38.67.59.4
Pulp and paper products275.163.6144.33.73.85.30.60.8
Textiles and textile articles719.51,307.92,333.424.926.513.812.313.4
Footwear54.2130.0250.53.41.91.01.21.4
Stone, cement and ceramic products65.5203.1292.50.81.01.31.91.7
Precious metals22.0127.867.11.51.50.41.20.4
Base metals682.91,119.11,387.52.52.113.110.58.0
Machinery and electrical equipment290.0817.81,829.510.211.65.67.710.5
Vehicles, aircraft and vessels338.81,134.21,475.11.31.06.510.78.5
Optical equipment53.3161.2310.61.00.61.01.51.8
Arms0.15.42.0– –– –– –0.1– –
Miscellaneous manufactured goods297.6591.9956.29.77.55.75.65.5
Works of art and antiques7.359.265.9– –– –0.10.60.4
Total5,209.610,611.417,377.7100.0100.0100.0100.0100.0
Imports 1/
Live animals, animal products26.9131.6445.61.01.10.51.12.0
Vegetable products88.9291.5581.97.610.11.72.42.6
Animal, vegetable fats and oils23.5138.8257.50.60.90.51.21.1
Food, drink and tobacco307.51,203.82,138.25.75.76.010.19.5
Mineral products1,437.21,877.82,969.17.512.028.015.813.2
Chemicals270.9737.31,621.213.07.35.36.27.2
Plastics and related products119.6384.0858.93.84.22.33.23.8
Hide, skins and leather29.379.6190.40.72.70.60.70.8
Wood and wood products25.493.3300.90.30.60.50.81.3
Pulp and paper products175.6244.4569.71.91.83.42.12.5
Textiles398.41,247.62,230.423.119.07.810.59.9
Footwear57.4119.5338.32.61.91.11.01.5
Stone, cement and ceramic products58.3145.4393.41.10.91.11.21.7
Precious metals23.862.262.7122.00.50.50.3
Base metals213.9613.61,325.08.97.44.25.15.9
Machinery and electrical equipment958.72,122.94,684.612.714.018.717.820.8
Vehicles, aircraft and vessels706.61,681.42,240.53.43.813.814.19.9
Optical equipment76.3286.9635.41.41.61.52.42.8
Arms2.629.037.0– –– –0.10.20.2
Miscellaneous manufactured goods121.4346.5647.43.43.02.42.92.9
Works of art and antiques8.183.825.20.1– –0.20.70.1
Total5,130.311,920.922,553.3100.0100.0100.0100.0100.0
Sources: Bank of Estonia; and Department of Statistics.

Covers only identified imports.

Sources: Bank of Estonia; and Department of Statistics.

Covers only identified imports.

By late 1991 and early 1992, the disintegration of the Soviet Union disrupted trading relationships and led to a breakdown in the payments system. With the accompanying move toward trade at world market prices, which particularly affected the prices of energy imports from Russia, Estonia suffered a 40 percent deterioration in its terms of trade. Interruptions in supplies also led to widespread fuel shortages during the winter. While changes in the exchange regime make comparison difficult, the total value of trade is estimated to have plunged in 1992, perhaps by as much as three quarters.

The process of reorientation in trade toward Western Europe and away from the former Soviet Union also began in 1992. Exports in U.S. dollar terms to countries outside the former Soviet Union (FSU) quadrupled in 1992, albeit from a tiny base, with Finland and Sweden accounting for most of the growth. While a number of factors were at work (see below), the very high initial profitability of such trade created a strong incentive. On the import side where the share of non-FSU trade rose from 10 percent to nearly 50 percent, this was mostly due to the shrinkage of trade with the FSU, since other imports remained approximately unchanged.

In 1993 and 1994, merchandise trade rebounded strongly from the low point of 1992. Export volumes nearly doubled over the two-year period, as products and marketing were adapted increasingly toward western markets, and benefiting also from recovering demand in Finland and Sweden in 1994. Nevertheless, the trade deficit increased in 1994, as import volumes grew by 56 percent, almost all of which was due to an expansion of trade with non-CIS countries. Imports of machinery and electrical equipment grew particularly strongly in 1994, and accounted for 21 percent of total imports during the year.

By 1994, the share of Estonia’s exports and imports with non-CIS trading partners was 70 percent and 80 percent, respectively. Indeed, Estonia has experienced the most rapid reorientation of trade among the fifteen countries that emerged following the collapse of the U.S.S.R.. A number of factors have been at work in Estonia’s rapid reorientation toward trade with the West:

(i) Estonia has benefitted from the natural advantage of its location. It is near to, and has had historical trading and cultural links with, the Nordic countries as well as other European countries on the Baltic Sea. By 1994, Finland was Estonia’s most important trading partner, accounting for 20 percent of Estonian exports and 37 percent of imports, while Sweden and Germany were also key trading partners. At the same time, Estonia is favorably positioned between West and East, and has been able to exploit this location with entrepôt trading activity. In particular, re-export trade in Russian scrap metals, some illegally imported, was important in 1992-93, although it declined in 1994. In the other direction, an active trade has developed in re-exporting used cars to Russia. 1/

(ii) Estonia appears to have had an industrial structure which was closer to its comparative advantage than many other former Soviet countries. Restructuring has occurred as Estonia has been confronted with world prices, including in agriculture, chemicals, and some parts of the textile industry; nevertheless, the broad commodity structure of exports has not changed dramatically since 1990. Instead, Estonia has been able to adapt existing resources and production capacity for such goods as wood and wood products, furniture, and certain textiles relatively quickly to Western needs. Of course, the low real value of the kroon at its introduction was also a factor in attenuating pressure for restructuring.

(iii) At the same time, the authorities’ policies have established an economic environment which is conducive to external trade, investment and growth. From early 1992, Estonia established a highly liberal external trading regime (see below), and payments for current and capital account transactions were liberalized in 1992 and 1994, respectively. Price signals in both output and factor markets have been largely unrestricted (see section II. 2), while a liberal investment law (1991) created certain incentives for foreign investors, 1/ and otherwise accorded them equal terms vis-à-vis domestic investors. Rapid privatization and policies to enforce hard budget constraints have further strengthened the role of market forces in investment and production decisions (see section II. 6). Finally, macroeconomic policies including the currency board mechanism and the ongoing commitment to a balanced budget, have led to a rapid reduction in inflation, clarifying price signals, enhancing confidence, and supporting the resumption of growth.

Estonia’s trade with the CIS in 1994 continued to decline as a share of total trade, particularly in volume terms. More than half of imports from CIS countries are energy, with imports of petroleum products and natural gas from Russia most important. Demand for these imports has risen less rapidly than for others as Estonia becomes more energy-efficient, and some trade with western countries has begun; Russia’s interruption of fuel oil supplies during December 1994-March 1995 may hasten the process of substitution. Estonia exports electricity and agricultural products to Russia and other CIS states, including especially dairy products and processed foods to Russia. Russia doubled its import tariffs applying to Estonia from July 1, 1994, but Estonian exports appeared not to diverge substantially from the trend of growth in value terms. This is likely due to the real appreciation of the Russian ruble, as well as relative price increases in the Russian market on goods such as processed foods in which Estonia is an important supplier. With the steep real appreciation of the Russian ruble over the course of 1993, the average level in 1994 continued to appreciate (Chart 6), helping to stabilize the CIS’ share of export values at 30 percent of total.

CHART 6ESTONIA REAL EFFECTIVE EXCHANGE RATE

(1993=100)

Sources: Estonian authorities, IMF International Statistics; and staff estimates.

1/ Trade weighted using data for 1993, upward movement implies appreciation.

2. Services

The surplus on nonfactor services nearly doubled in U.S. dollar terms from 1993 to 1994. The main sources of growth were the substantial growth in net receipts from sea transport services, including both freight and passenger services, as well as tourism. Estonia inherited a large (although aging) merchant shipping fleet from the former Soviet Union, and benefits from the port of Tallinn which is deep, ice-free, and has capacity to handle grain and a limited amount of petroleum products. Freight shipping services have remained profitable, especially in transporting goods between Russia and other parts of Europe. Passenger transport receipts are mostly related to ferries to Finland and Sweden, and such services experienced rapid expansion during the first three quarters of 1994 due to increasing tourism. The disastrous sinking of a passenger ferry on September 28, 1994 reduced fourth quarter earnings for passenger services, although a replacement ship was in operation by December. The largest debit item in nonfactor services was technical assistance, which declined in 1994; the counterpart of technical assistance is included in official transfers.

The deficit on factor services increased to US$33 million in 1994. Factor service payments are principally dividends on foreign direct investment, most of which were reinvested and are reflected in further foreign direct investment inflows. With Estonia’s very small public debt, interest payments have remained small, and are outweighed by interest receipts on the Bank of Estonia’s foreign assets.

3. Transfers

In 1992, Estonia received official transfers equivalent to US$95 million in the form of grain from the EU and the United States. Since then transfers have been dominated by the counterpart to technical assistance, which has been declining. Other official transfers are made up largely of Russian pension payments to military personnel residing in Estonia. Recorded private transfers remained negligible. However, it is estimated that at least several thousand undocumented Estonians are working in Finland. While part of their earnings may be remitted to Estonia, these flows are not recorded in the balance of payments.

4. Capital account

Foreign direct investment has dominated capital inflows since 1991, and total inflows increased again in 1994 to US$253 million. This represents US$170 per capita, or 9 1/2 percent of GDP, among the highest in the world by either standard and substantially higher than the other Baltics, Russia, or other countries of the FSU. Estonia’s success in attracting foreign investment has been based on rapid economic reforms, a stable currency, relatively low costs, a liberal foreign investment law combined with a large-scale privatization program which has actively encouraged foreign investor participation, lack of capital controls, and geographic and historical ties to Western Europe and Russia. Since 1992, foreign capital has been invested mostly in manufacturing (36 percent), trade (32 percent), and communications (15 percent), with the major sources of capital being Sweden, Finland, and Russia. Approximately two thirds of foreign direct investment inflows has been in the form of equity investments, with the remainder composed of loans extended to companies by their foreign equity holders and reinvested earnings.

Official lending to Estonia in 1992 took place mostly in the form of concessional grain import financing from the United States and short-term energy credits from Finland. Lending accelerated in 1993 with total official disbursements of US$69 million, including the first tranche of a multi-purpose EU loan, and a loan from Sweden under the aegis of the EU/G-24 assistance package for infrastructure and energy. Disbursements of the 1992 World Bank import rehabilitation loan accelerated to US$19 million, with co-financing from the Japanese Export-Import Bank (JEXIM).

Disbursements of official loans slowed to US$33 million in 1994. The second tranche of the EU loan (ECU 20 million), intended mostly for onlending to domestic banks for medium-term projects, was delayed as the Government discussed how to use the small share allocated to support families. Disbursements under the World Bank critical imports loan were completed in 1994, and lending began on the US$12 million highway maintenance loan. JEXIM import financing and EBRD energy and airport development loans comprised most of the other lending.

Estonian commercial banks use deposits held in banks abroad for liquidity management. Net outflows have taken place during the last three years as perceived lending opportunities in Estonia have not kept pace with available liquidity. An acceleration in these outflows occurred in 1994, due to the effective reduction in the reserve requirement in July (see section III. 1).

5. Official reserves

In the beginning of 1992 Estonia had virtually no official international reserves, but during the course of the year reserve holdings were boosted by the restitution of pre-war gold by the Bank of England, the BIS, and Sweden. Under the currency board arrangement, changes in net international reserves correspond to changes in base money, with a small additional margin due to fluctuations in the foreign holdings of the Bank of Estonia’s Banking Department. Net international reserves rose by US$157 million in 1993 and by US$29 million in 1994. Estonia did not use Fund credit in 1994, although it was eligible to do so, and outstanding use of Fund credit at end-1994 was SDR 47.5 million. 1/

6. External debt

At end-1991, Estonia had no external debt. 1/ Since that date, Estonia’s careful policy with regard to foreign borrowing has kept foreign debt low, and at end-1994 official external debt (including use of Fund credit) was US$173 million, equivalent to 6 1/2 percent of GDP. Payments of principal and interest on official loans represented less than 1 percent of exports of goods and nonfactor services.

VI. Trade, Payments, and Exchange System

1. Trade system

A fundamental objective of Estonian policy since regaining independence in 1991 has been to re-establish trading links with the world outside of the former Soviet Union. Broad public support for a large “window to the West” overrode sectoral concerns, and Estonia quickly dismantled the restrictive trading regime existing under the Soviet Union, and established one of the most liberal trading regimes in the world. Import tariffs were almost completely eliminated in early 1992, and currently apply only to furs and fur products (16 percent), and cars, motorcycles, bicycles, and recreational boats (all 10 percent). Other commercial policy restrictions have also been nearly eliminated in the years since 1991. However, some protection of tobacco and alcoholic beverage industries remains, with excise duties imposed on imports which are higher than those applying to domestic production. 1/ Excise duties are also imposed on petroleum products. A 0.5 percent ad valorem processing fee is charged for all imports and exports, but Parliament is considering replacing it by a flat fee of EEK 200. There are no import quotas, and licensing requirements are not generally restrictive, applying to products with health, safety, or national defense importance, as well as for alcohol, tobacco, and metals (to help control illegal trade). Quantitative restrictions on exports have now been completely eliminated, with the removal on October 18, 1994 of the remaining quotas on gravel, specialized clay, and quartz sand. Export tariffs apply only to items of cultural value, including art and antiques, at a rate of up to 100 percent.

Estonia has also negotiated preferred access to key markets for its exports. A free trade agreement with the European Union was signed on July 18, 1994 and came into effect on January 1, 1995 (with no transition period). Under this agreement, trade in manufactured goods will be unrestricted, although Estonia will need to provide certificates of origin for textile exports. Agricultural exports remain subject to quotas. In early 1995, Estonia and the EU were nearing accord on an Association Agreement, which would regulate trade in services, labor movements, and companies’ rights to establish subsidiaries. The authorities’ ultimate objective is full membership in the EU. Free trade agreements have also been signed with each of the Nordic countries and Switzerland (in 1992), and with the other Baltic countries (in 1993). Russia and Estonia agreed in principle on a most-favored-nation treaty in 1993, but it remains unratified, and from July 1, 1994, Russia doubled its tariffs on imports from Estonia.

2. Exchange system and payments arrangements

Since its introduction on June 20, 1992, the kroon has been fully convertible for current account transactions. Estonia accepted the obligations of the Fund’s Article VIII, Sections 2, 3, and 4 as from August 15, 1994. The Bank of Estonia guarantees the conversion of kroon bank notes and reserve deposits into deutsche marks and vice versa at a fixed exchange rate of EEK 8 per deutsche mark. The Bank of Estonia also stands ready to transact in 13 other convertible foreign currencies with domestic banks, as a service to smaller banks. Estonia also maintains no restrictions on international capital transactions. With the annulment of the Foreign Currency Law on March 23, 1994, individuals may open foreign currency accounts in domestic banks or abroad.

Following currency reform in June 1992, Estonia signed payments agreements to set up correspondent accounts with the other Baltic countries and every CIS country except Georgia. These accounts do not involve restrictive features, since the Bank of Estonia acts only as an intermediary, takes no net position, and does not convert any balances into kroon. The Bank of Estonia also encourages enterprises to effect payments through commercial banks which have begun to trade in other Baltic and CIS currencies, and such arrangements accounted for about 70 percent of payments by end-1994. Nevertheless, payments with the other Baltic states, Russia, and other countries of the former Soviet Union remain difficult, and are largely denominated in convertible currencies. 1/

Industrial output and national accounts statistics (as well as those for the labor market) are still unsatisfactory. Although national accounts data are compiled according to the 1993 SNA methodology, the coverage of the reporting system remains narrow. The insufficient coverage of the newly emerging private sector is likely to be reflected in an underestimation of aggregate output growth, since the output performance of the state enterprise sector appears to be weaker than that of the private sector. In addition, growth rates may be biased downward by the fact that incentives to overstate production in the planned economy have given way to strong incentives to report as little revenue as possible. Estimates of real GDP in this report are based on deflators derived from consumer and producer price indices and export and import unit values, and should be considered preliminary.

Russia doubled its tariffs on imports from countries without MFN status.

The clothing industry was much quicker than the textile industry to adjust to the new conditions. Faced with low quality textiles produced domestically, clothing manufacturers quickly switched to higher quality imported inputs. The more capital intensive textile industry first experienced a disruption in input deliveries, but was also unable to attract sufficient new capital to upgrade its machinery for higher quality production.

A project to create a computerized real estate data system which will facilitate and expedite the land reform is in preparation since September 1993. It is expected that the system will become operational in 1996.

This measure of unemployment is based on household survey data of the Estonian Market Operation Research Institute (EMOR). The institute follows the standard ILO definition to arrive at its unemployment rate. The official unemployment rate published by the Estonian Government considers as unemployed only those job seekers who receive unemployment benefits. The official unemployment rate is then expressed as the share of the unemployed in the working age population. This measure would indicate an unemployment rate of under 2 percent for 1994 which is more a reflection of the tight eligibility rules to receive unemployment benefits rather than the true level of unemployment in the economy.

In fact, in household surveys, 20 percent of the unemployed have indicated having lost their jobs due to liquidation of the company and 30 percent due to reorganization.

The Law on Labor Contracts provides for severance pay for full-time employees upon termination of employment of between four to eight monthly salaries according to length of service.

Given certain conditions, employees’ working time and correspondingly their compensation, can be reduced to 60 percent of their regular employment. Employees on partly compensated leave are only required to be paid at least 60 percent of the minimum wage rate.

Urve Venesaar, “Labor Market In Estonia”, Working Paper No. 11, Institute of Economics, Estonian Academy of Sciences, June 1994.

Nevertheless, regional labor mobility remains to be hampered by the lack of housing, and high transportation costs, and regional disparities in unemployment continue to persist.

Previously, unemployment benefits were linked to the minimum wage and amounted to 60 percent of the minimum wage. When the minimum wage was increased from EEK 300 to EEK 450 per month on September 1, 1994, the unemployment benefits were de-linked and remained at their original level.

Less than 50 percent of all jobseekers contact the employment offices at all, as they rely on other information sources. These offices are currently being computerized in order to improve the information available to jobseekers.

Price setting on some services (electricity, heating, water, sewer, public transportation, communication, airport and port services) and goods (oil shale, natural gas, liquor, fuels and lubricants, empty bottles, forest resources) provided by state and municipal enterprises remains subject to review. In most instances, costs are ultimately fully passed-through.

Excluding administered price increases, the CPI increased by only 27 percent during 1994.

The real appreciation of the ruble allowed Estonian exporters to raise prices in the export market while import prices rose less due to a large share of energy products in Estonia’s imports from Russia which are priced at world market levels.

Imports from Russia may have also contributed to higher consumer prices in Estonia, although to a lesser extent. The bulk of these imports are energy products, priced at world market levels. In 1993, for example, 35 percent of Estonia’s exports to Russia were foodstuffs, while Russian imports had only a 5 percent foodstuff component.

At the same time, the minimum wage was redefined from a monthly to an hourly basis.

The emphasis on business plans and new investments has strongly biased the sale of enterprises against management or employee buyouts, which often have inadequate access to capital resources.

Although only Estonian citizens and residents are permitted to hold vouchers.

Foreign loans have to be approved by Parliament, but their associated outlays do not pass through the budget approved by Parliament.

The financial balance is the overall balance excluding net lending operations.

The new income tax law became effective on January 1, 1994. The progressive rate structure for personal income tax which prevailed in 1993 produced an effective average statutory rate of about 30 percent; this was replaced by a flat rate of 26 percent in 1994, where a part of income is exempted. The rate of corporate income tax throughout 1993 was 35 percent and this was replaced by a flat rate of 26 percent in 1994. A new VAT law also became effective from January 1, 1994, which clarified various aspects of the law but retained the 18 percent tax rate.

The tax authorities are aware of evasion of personal income tax through undocumented payment of wages and understatement of wage rates.

Various administrative measures will be taken in 1995 to attempt to overcome these problems. These measures include the introduction of tax stamps on tobacco and amended regulations about use of cash registers and provision of receipts and invoices.

Central government consolidated expenditure rose by 3 1/2 percentage points of GDP (with wages increasing by 2 1/4 percentage points of GDP). Local government expenditure declined by 6 percentage points of GDP (with transfers and subsidies declining 3 percentage points of GDP and wages declining 1 percentage point). These changes mainly reflect the transfer of responsibilities between local and central government. Social Insurance Fund expenditure declined by 1 1/2 percentage points of GDP, and Medical Insurance Fund expenditure declined by 1/2 percentage point of GDP.

However, plans are under way to develop a reasury function by end-1995 and this may involve some small issues of treasury bills.

To facilitate coordination of government operations, the fiscal years of central and local government will be re-unified with effect from January 1, 1996.

During the year, Parliament will consider a proposal for land tax to accrue in its entirety to local budgets.

Parliament approved an increase of 20 percent in these wages as of January 1, 1995.

This was the first of several half-yearly steps that will raise them by five years, to 65 for men and 60 for women by 2003.

The public pension is the basic entitlement upon reaching retirement age and is the base level from which all pensions are calculated. Depending on length of working service, old-age/retirement pensions range from 1-1.7 times the public pension. Disability pensions range from 80 percent to 125 percent of the public pension--depending on degree of disability. Survivors’ pensions (for dependents incapable of gainful economic activity, upon the death of the breadwinner) range from 100 percent to 125 percent of the public pension.

Pensions may be increased in April and September of each year without Parliamentary approval, depending on the revenue collected in the Social Insurance Fund’s pension foundation.

The social tax rate is 33 percent of payroll and revenue equivalent to a tax rate of 20 percent accrues to the Social Insurance Fund; the remainder accrues to the Medical Insurance Fund.

Proposals to introduce a means-test were rejected by Parliament and the feeling of the authorities is that currently the costs of means-testing outweigh the benefits. The benefit is related to age, number and disability of children as well as whether there are nonworking or single parents.

The budget assumes 717,000 total recipients of family benefits.

A more comprehensive description of the financial system is presented in the Recent Economic Developments report for the 1994 Article IV Consultation (SM/94/81, 3/29/1994).

Estonia remains largely a cash economy as almost all mages and retail trade are paid in cash.

The spread on these contracts was from EEK 7.999 to EEK 8.001 only, the same as for spot transactions; the rates for spot transactions was reduced from EEK 7.998 to EEK 8.002 in the first quarter of 1994.

A more detailed description can be found in EBS/94/196, 9/29/94 on pages 5, 6, and 10.

The Bank of Estonia started offering certificates of deposit in order to provide banks with an asset which could be used as collateral in interbank operations.

The Bank of Estonia hold its certificate of deposit auctions every other week.

The Bank of Estonia has increased the minimum subscribed capital (Tier 1 capital) for commercial banks from EEK 6 million at present to EEK 15 million by April 1, 1995, to EEK 25 million by April 1, 1996 and to EEK 35 million by April 1, 1997 for existing banks. For new banks, the required minimum capital stock of EEK 15 million in 1994 will be raised to EEK 25 million in 1995 and to EEK 35 million in 1996. In addition, from January 1, 1996 banks are required to maintain subscribed capital plus reserve funds (Tier 1 and Tier 2 capital) of at least EEK 50 million.

The share of trade with the states of the Soviet Union may be overstated in 1991, as it is valued using the commercial exchange rate of Rub 1.8 per US$1, while market rates for the ruble were much higher.

Indeed, it is thought that merchandise trade data may be inflated by the inclusion of transit trade, such as in metals, which should be reported separately.

The differential tax treatment of foreign and domestic investors has been eliminated in 1994.

Four drawings under the stand-by arrangement and the second STF purchase were made in early 1995, totaling SDR 20.9 million.

However, the question of Estonia’s share of the external debt (and assets) of the Soviet Union has not been resolved. In addition, some Rub 3 billion of banks’ assets were frozen in Moscow and there are outstanding claims on the Vneshekonombank (Rub 850 million). The outstanding debit balance on the Bank of Estonia’s inoperative correspondent account with Russia is about Rub 3.7 billion. Estonia’s position is that all claims are offsetting.

The Estonian authorities intend to eliminate this protective margin in 1995.

A second set of correspondent accounts with the other Baltic countries, Russia, and other countries of the FSU operated between January 1, 1992 and June 20, 1992. The Bank of Estonia is attempting to resolve various technical issues involved with the accounts, but some of the claims remain under dispute.

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