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Successful transition: Estonia establishes itself as market economy in position for accession to European Union

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2001
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In 1991, after five decades of Soviet rule, Estonia regained full independence. It was left with an inefficient planned economy and large, albeit repressed, macroeconomic imbalances. Moreover, historical trade links to Scandinavian and other countries, dating back to the Hanseatic League and surviving under Swedish and Russian rule, had been severed during the Soviet occupation. The challenges of transition to a market economy and reintegration into the world economy seemed daunting indeed.

After a decade of independence, Estonia has established itself as a well-functioning market economy and a front-runner for accession to the European Union (EU). The cornerstones of its successful transition were the fast privatization of public enterprises with reliance on strategic foreign investors, a free trade regime, the early creation of a legal framework for private activity, full convertibility for current and capital account transactions, and a transparent policy framework, including the currency board arrangement. These reforms were expedited by the departure of most of the old political and economic elite and supported by a strong public determination—represented by the newly acquired democratic process—to free the economy from the legacies of Soviet planning. The successful implementation of IMF-supported programs (see below) and the prospect of EU accession also helped to provide a social and political catalyst for reform, as did financial and technical assistance from neighboring countries. Geographical advantages, such as ice-free ports and proximity to Helsinki, also played an important role. After 10 years of transition, challenges remain, but the medium-term outlook for the Estonian economy appears bright.

Ten years of transition

Following independence, Estonia’s main reform goal was to curtail the role of the state while putting in place the mechanisms that would allow the country to operate as a market economy. The legal framework for private activity, including effective bankruptcy legislation, was enacted in September 1992. Privatization of small-scale enterprises, mostly shops and restaurants, had already started in March 1991 and was largely completed by the end of 1992. In June 1993, the Estonian Privatization Agency (EPA) was created to oversee the privatization of public enterprises. The EPA adopted the approach followed by the Treuhand in the former east Germany: large public enterprises, most of them in their entirety, were sold to strategic foreign investors that were willing to provide new investments and know-how to modernize the production process. This approach, together with the emigration of most of the old political and economic elite, successfully averted the governance problems and the “state capture” by vested interests that plagued privatization programs elsewhere. By the end of 1994, the agency had privatized more than 50 percent of all large public enterprises, and the share of the private sector in GDP began to exceed that of the public sector. The job of the EPA has been completed this year, with only a portion of the electricity sector left to be privatized.

The second goal of reform was to create an environment conducive to foreign trade and investment. Full convertibility for current account and most capital account transactions was established in June 1992.

Estonia: growth and inflation

Note: Official statistics probably overestimate the output decline in the earlier years (1991 -93), as output at the beginning of transition was measured at inflated prices. See Anders Aslund, The Myth of Output Collapse After Communism, Carnegie Endowment Working Paper 18, 2001.

Data: Estonian authorities

Virtually all trade restrictions inherited from the former Soviet Union were dismantled at the same time. While a few tariffs on selected agricultural products were introduced in 2000 in preparation for EU accession, Estonia’s trade regime remains one of the most liberal in the world.

An important priority of economic reform from the beginning was the achievement of macroeconomic stability. Most prices had already been liberalized by the end of 1991, but inflation became rampant throughout the ruble zone. In Estonia, inflation peaked at 80 percent a month in early 1992, while the economy was contracting sharply (according to official statistics, output declined by 19 percent in 1992, but the decline is probably overestimated, given the overvaluation of production during the Soviet period). Radical macroeconomic reform was needed, and public opinion was strongly behind this reform movement.

On June 20, 1992, the government created a new currency, the Estonian kroon, pegged at a fixed exchange rate of 8 krooni for 1 deutsche mark. The peg was guaranteed by a currency board arrangement, which by law required the Bank of Estonia to hold 1 deutsche mark of reserves for every 8 krooni in circulation or in bank deposits at the central bank. The currency board was a success: inflation fell from 1,069 percent in 1992 to 48 percent in 1994 and economic growth resumed (see chart, page 303). Under the currency board arrangement, the Bank of Estonia could no longer provide any domestic financing, either to the government or to commercial banks, except under exceptional circumstances. Before the currency reform, therefore, the government had to decisively cut its fiscal deficit to achieve a budget that could be appropriately financed. This established the important principle that fiscal policy needed to be subordinated to the currency board arrangement, a principle that has resulted in a very prudent fiscal policy for the past 10 years.

Estonia: selected economic indicators

(percent of GDP, unless otherwise indicated)
19961997199819992000
Real GDP (percentage change)4.010.45.0-0.76.9
CPI (average percentage change)23.111.28.13.34.0
Unemployment rate (percent)10.09.79.912.313.7
General government balance-1.52.2-0.3-4.6-0.3
Total public debt8.07.66.47.26.2
Exports of goods and nonfactor services67.178.479.777.295.4
Imports of goods and nonfactor services78.690.090.182.1100.4
Current account balance-9.2-12.2-9.2-4.7-6.4
Gross international reserves
(millions of DM)9951,3631,3641,6671,942
Data: Estonian authorities

As a consequence, private sector activity started to thrive, particularly in small and medium-sized enterprises, driving output growth in the second half of the 1990s. The banking sector, liberalized at the end of Soviet rule, expanded rapidly in 1991-92. By the time of the currency reform, 41 banks were in operation. A period of consolidation followed, partly because of bank failures but also because of stricter licensing requirements and more stringent banking supervision, which led to a number of closures and mergers. By the end of 1997, the number of banks had fallen to 11.

The resilience of the Estonian economy was tested by the crises that erupted in Asia in 1997 and Russia in 1998. Between 1996 and 1997, Estonian banks overextended their portfolios, and exposure to external shocks was growing. When the Asian and Russian crises hit, foreign credit lines to commercial banks were suddenly withdrawn at the same time as the quality of the loan portfolio was deteriorating. These sudden shocks strained the Estonian banking system. Following the Russian crisis, economic activity also suffered because of the loss of a major export market, resulting in a brief recession in 1999. However, the problems in the banking system were resolved swiftly. In late 1998, Swedish banks bought majority stakes in the two largest Estonian banks. Smaller insolvent banks were closed or forced to merge with larger ones. One bank was taken over by the Bank of Estonia, restructured, and sold to foreign investors in 2000. Major foreign banks now control over 95 percent of all commercial banks’ assets, and only six banks are currently in operation. According to a recent IMF-World Bank Financial System Stability Assessment, the health of the banking system has been restored and banking supervision has been substantially strengthened. Indeed, Estonian banks are increasingly playing an important role in neighboring countries, and non-bank financial services are expanding rapidly.

In May 1992, Estonia joined the IMF, which has been an important partner in Estonia’s transition process. In September of that year, the IMF Executive Board approved a Stand-By Arrangement for $40 million in support of the reform effort; a second arrangement followed in 1993 for an additional $16 million, together with financial support to the government of $32 million under the IMF’s Systemic Transformation Facility (a temporary facility established in April 1993 to provide financial assistance to transition economies. No purchases have been possible under this facility since the end of December 1995). The IMF also provided technical assistance in a number of areas, including central and commercial bank regulations, banking supervision, tax policy and administration, and statistics. Four precautionary arrangements spanned the period April 1995-August 2001. While no financial resources were disbursed during this period, IMF-supported programs provided a catalyst for social and political consensus on economic reforms. More recently, the goal of EU accession began to play a similar catalytic role.

Is the transition over?

The Estonian economy now bears little resemblance to the planned economy of a decade earlier. Between 1995 and 2000, economic growth averaged 5 percent and inflation declined to 4 percent (see table, this page). By 2000, exports of goods and nonfactor services accounted for 95 percent of output, the fiscal accounts were broadly in balance, and public debt was very small. According to the 2000 transition report of the European Bank for Reconstruction and Development, Estonia has achieved advanced economy standards in small-scale privatization and trade and foreign exchange systems, and is near those standards for large-scale privatization and the banking system. Estonia ranks ahead of many advanced economies in terms of competitiveness and transparency indicators, and its future prospects are very favorable. Notwithstanding the short-term risk of a sharp slowdown in the world economy, Estonia should be able to grow rapidly over the medium term, as prudent policies, low labor costs, and good EU accession prospects attract large foreign direct investment inflows. In turn, this should continue to support substantial improvements in living standards, thus narrowing the gap with EU income levels.

Challenges remain, however. Accession to the North Atlantic Treaty Organization and the European Union require significant additional spending, which may produce tensions within the government’s balanced budget policy. The privatization of the energy power generators should be completed this year, but the electric distribution network remains in public hands. While agriculture is now fully privatized, land restitution has proved to be a drawn-out process. More important, the transition to a market economy has left a portion of the population behind. Unemployment—mostly concentrated in the Russian minority living in the northeastern region of the country—remains stubbornly high as a result of a skills mismatch, language differences, and limited geographical mobility. On balance, transition can be considered over in Estonia insofar as the establishment of a well-functioning market economy is concerned. Legacies of the past, however, remain, especially in the labor market, where only a longer period of sustained economic growth will integrate all members of society into the newly established market economy.

Although Estonia had important historical and geographical advantages, its success can be attributed as much to the country’s radical reforms and stringent fiscal policies, which were transparent and enjoyed strong public support. The privatization with reliance on strategic foreign investors brought know-how, management skills, and good corporate governance. The early elimination of current account, capital account, and trade restrictions established an environment conducive to foreign trade and investment. The currency board arrangement provided a stable policy framework. All these reforms created a transparent framework that allowed a vibrant market economy to prosper.

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