Chapter

VII The Baltic Countries and Accession to the European Union

Author(s):
Françoise Le Gall, L. Psalida, Pietro Garibaldi, Julian Berengaut, Jerald Schiff, Kerstin Westin, Augusto López-Claros, Richard Stern, and Dennis Jones
Published Date:
November 1998
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Author(s)
Ann-Margret Westin

Since 1993, the relationships between the European Union and the three Baltic countries, Estonia, Latvia, and Lithuania, have deepened through a variety of agreements aimed at further developing economic and political relations and, ultimately, integration with the EU. The most important agreements have been the Agreements on Trade and Commercial and Economic Cooperation, which came into force in February and March 1993; the Free Trade Agreements, which came into force on January 1, 1995; and the Association, or Europe Agreements, which were signed in June 1995 and came into force in February 1998. Through these Agreements, the Baltics asserted their intentions to become fully integrated with the EU. They formally applied for EU membership in the fall of 1995.

Pre-Accession Strategy for the Associated Countries of Central and Eastern Europe—the Baltics

At the Copenhagen summit in 1993, it was decided “that the associated countries in Central and Eastern Europe that so desire shall become members of the European Union. Accession will take place as soon as an associated country is able to assume the obligations of membership by satisfying the economic and political conditions required.”1 At the same time, the economic and political conditions that had to be fulfilled for membership were also defined. The following year, at the Essen summit in December 1994, it was confirmed that the countries of central Europe could become members in the EU, and the Union's accession policy was refocused toward these countries in light of their future membership. In particular, a “pre-accession strategy” was determined, which outlined the means through which the Union would assist the associated countries in their integration. The strategy, which was tailored to meet the needs of those countries with which Europe Agreements had been concluded or would be concluded in the near future, encompasses the following: the Association Agreements, whereby the EU offers associated countries the trade concessions and other benefits that are normally affiliated with full membership; the creation of a “structured dialogue,” which provides a framework through which associated countries and member states can discuss issues of common concern; financial grants, policy advice, and training through the Phare Program; and a White Paper on “legislation harmonization.” A list of the Association Agreements signed between the EU and central and eastern European countries and the formal membership applications submitted is provided in Table 7.1. As noted in the table, while the Association Agreements of the Baltic countries just recently came into effect, that of Slovenia, the last one to be signed, is still being ratified. Reviewed below are the general accession conditions and the pre-accession strategy for EU membership that apply to the associated countries of central and eastern Europe and their relevance for the three Baltic countries, and the possible timetable for accession negotiations and, ultimately, EU membership.

Table 7.1.Association Agreements and EU Membership Applications of Central and Eastern European Countries
CountryAssociation Agreement SignedAssociation Agreement Came into ForceOfficial Application for EU Membership
BulgariaMarch 1993February 1995December 1995
Czech RepublicOctober 1993February 1995January 1996
EstoniaJune 1995February 1998November 1995
HungaryDecember 1991February 1994March 1994
LatviaJune 1995February 1998October 1995
LithuaniaJune 1995February 1998December 1995
PolandDecember 1991February 1994April 1994
RomaniaFebruary 1993February 1995June 1995
SlovakiaOctober 1993February 1995June 1995
SloveniaJune 19961June 1996
Source: Commission of the European Communities.

Still being ratified.

Source: Commission of the European Communities.

Still being ratified.

Admission Criteria

At the 1993 Copenhagen summit, the European Council listed the economic and political conditions that the associated countries in central and eastern Europe would have to satisfy to become members of the EU. These criteria were (1) stability of institutions guaranteeing democracy, the rule of law, human rights, and respect for the protection of minorities; (2) the existence of a functioning market economy and the capacity to cope with competitive pressures and market forces within the EU; and (3) the ability to take on the obligations of membership, including adherence to the aims of political, economic, and monetary union. A fourth precondition was subsequently added, stating that the EU itself should show that it had the capacity to handle new members without slowing the momentum of the European integration process.

The criteria set by the European Council were very general and failed to provide any concrete definitions or guidelines on what exactly would be required of the associated countries. Therefore, during the Copenhagen summit, France made a proposal (known as the “French list”) including a more detailed description of the admission criteria. According to the list, the general state of development of the economy could be measured in terms of GDP per capita while the functioning of the market economy could be measured by the extent of privatization. It was also suggested that the criteria should include a demonstrated ability to deliver a quantifiable level of social protection, as well as control of public debt and inflation. Furthermore, it should be possible to assess the country's monetary and fiscal policies, including convertibility and stability of the local currency and policies on capital movements. There should be an efficient banking system. Also, the economy's degree of openness should be measurable in terms of the proportion of external trade in GDP and the impact of the country's economy on that of the Union. Finally, the capacity of national administrations to implement domestic and EU laws as well as the existence of a modern fiscal system should be included in the assessment of economic health.

Pre-Accession Strategy

Association (Europe) Agreements

The Europe Agreements are the most wide-ranging agreements that the EU has ever entered into. They cover political dialogue and economic integration as well as cultural and financial cooperation and are concluded for unlimited periods. The first Europe Agreements between the EU and central European countries were signed as early as 1991 but the agreements acquired greater political significance following the 1993 Copenhagen summit where EU membership of the associated countries was recognized as an objective shared by the EU. All countries that sign Europe Agreements become eligible for membership and, since the agreement on the pre-accession strategy at the 1994 Essen summit, these Agreements have become the main element of the framework within which countries work toward EU membership.2 A key element of the Europe Agreements is the series of bilateral meetings between the EU and each of the potential members, concerning, inter alia, the implementation of the pre-accession strategy and intraregional cooperation. The pre-accession strategy also introduces a number of measures to promote trade for the partner countries, and the Europe Agreements aim at gradually establishing free trade in industrial products over the transition period on an asymmetric basis: the EU, as the stronger economic partner, opens it markets more rapidly than the associated country.

The Europe Agreements signed between the EU and the three Baltic countries in June 1995 have since been ratified by the parliaments of the EU member countries and by the EU itself. The agreements came into effect in February 1998 and now fully supplant the previous trade and cooperation agreements; they also provide a political dialogue between the EU and the Baltic countries and include provisions on matters such as the establishment of firms, movement of workers and capital, supply of services, economic, cultural, and financial cooperation, and cooperation on prevention of illegal activities.

The general principles governing the three Baltic Agreements are more or less the same, with one important exception in that Latvia and Lithuania enjoy a transitional period, ending December 31, 1999, in the areas of trade liberalization and competition.3 No transitional period was provided for Estonia in light of the country's economic openness toward the rest of the world. In the framework of the Estonian Association Agreement, a free trade area was established between Estonia and the EU as of January 1, 1995, and no efforts to abolish supports and restrictions contradicting EU rules will be necessary. In Latvia, it has been agreed to gradually establish a free trade area with the EU over a transitional period starting January 1, 1995 and lasting a maximum of four years. The governing principles are those of the Association Agreement as well as those of the World Trade Organization and the “New” General Agreements on Tariffs and Trade (GATT) of 1994. Also, most of the few remaining export duties are to be abolished by the end of 1998 at the latest. Meanwhile, in Lithuania, remaining custom duties on exports and imports vis-à-vis the EU are to be abolished by January 1, 2001. In Latvia and Lithuania, all quantitative restrictions on imports and exports vis-à-vis the EU were abolished on January 1, 1995. Also, the EU, Latvia, and Lithuania have each declared their readiness to reduce custom duties more rapidly if the economic situation permits.

Structured Dialogue

At the Copenhagen summit, the EU agreed on a multilateral framework of regular joint meetings at the ministerial level between the Union and the associated countries. The structured dialogue provides a framework for the discussion of issues of common concern, including the Common Foreign and Security Policy and justice and interior issues. It also familiarizes prospective member countries with the EU's decision-making process and institutional setup. Since 1995, government leaders and EU ministers have been meeting their counterparts from the associated countries, including the Baltics, at regular intervals. Twice a year, heads of state and government have met during the European Council; foreign affairs ministers and ministers responsible for justice and interior affairs have also convened twice a year.

Phare Program

The Phare Program, which initially was developed as an immediate response to the structural challenges facing central and eastern European countries, has become one of the cornerstones of the pre-accession strategy.4 The program provides grants as well as policy advice and training to support partner countries through the process of economic transformation and strengthening of democracy. Through research studies, capital grants, guarantee schemes, and credit lines, the program acts as a catalyst by unlocking funds for important projects from other donors, but it also invests directly in infrastructure together with international financing institutions. The program has been implemented in cooperation with other international institutions to ensure consistency in policy and sector strategy and to avoid duplication of efforts; in fact, the Phare Program has worked closely with, and has provided know-how, training, and support to the IMF, the World Bank, and the European Bank for Reconstruction and Development. The Phare budget is determined by the European Parliament and the Council of the EU, and after six years of operation (1990–95), a total of ECU 5.4 billion has been made available to 11 partner countries.5 Funds through the Phare Program are allocated both to national and multicountry programs, with the latter most prevalent in the areas of environment, energy, transportation, nuclear safety, customs, and the fight against illegal drug trade.6

The Baltic countries have been part of the Phare Program since 1992 and have received assistance through both national and multicountry programs.7 Between 1992 and 1995, the three Baltic countries received a total of ECU 289.5 million, covering the provision of technical assistance, financial assistance (small and medium-sized firm credit lines), training, and limited supplies of equipment. In all three countries, the programs initially focused on macroeconomic stabilization and restructuring, including privatization, industrial restructuring, and financial sector development. The program for Estonia also included a number of strategy studies in the areas of energy, environment, and transportation, and in Lithuania, Phare funding was also used for the preparation of three large-scale studies in the areas of agriculture, transport, and energy.

Since 1995, the EU has prepared Multi-Annual Indicative Programs (MIPs) for the Baltic countries covering a total estimated allocation of ECU 430 million for the 1995–99 period. These programs are more concentrated in character and will focus on pre-accession preparations (including the implementation of Free Trade and Europe Agreements and the adoption of the internal market's acquis communautaire); medium-term restructuring (poststabilization economic development); infrastructure investment; and regional cooperation. The exact implementation of the MIPs differs among the three countries, with Estonia placing further emphasis on export development and public sector management while private sector development, agriculture, social sector and human resources development are receiving more attention in Latvia and Lithuania.

White Paper on Approximation of Laws

Within the framework of the Europe Agreements, the associated countries have begun approximating their legislative frameworks to move toward the economic freedoms that constitute the basis of the EU's internal market. Given the magnitude and complexity of this task, the European Council endorsed a White Paper in Cannes in June 1995 to help the countries prepare as rapidly and efficiently as possible.8 The White Paper sets out the body of essential internal market legislation divided into 23 sectors. These sectors cover, inter alia, the free movement of capital and persons, competition policy, social policy, agriculture, transportation, the environment, telecommunications, direct and indirect taxation, public procurement, financial services, energy, and consumer protection.

The Baltic countries generally face the greatest challenges in the areas of company legislation and contract enforcement; laws relating to the operation of the financial system; the protection of intellectual property rights; and competition policies. To create a secure and predictable environment in which companies can operate, national laws will need to be harmonized across Europe so that obstacles to a company's freedom to establish operations are removed and an equivalent degree of protection is provided throughout the Community. The development of the financial sector will be another key issue for the successful transition of the Baltic countries, requiring not only the existence of the basic legislative environment but also laws regulating the issuance and ownership of securities as well as the existence of regulated markets where securities are issued and traded. Enhanced intellectual property rights will also be important to ensure the proper incentives for innovation, research, and development. A final key challenge for the Baltics will be to improve their competition policies, one of the cornerstones for the creation of an internal market and a precondition for EU accession.

Timetable

Throughout the process, the Baltic countries have been insisting on exact timetables and on the importance of each country being dealt with separately, according to its own merits. In particular, during 1996 and the first half of 1997, Estonia argued repeatedly that the economic achievement of a country and not its geopolitical aspects must take priority in the admission of new members into the EU, and that, consequently, the economic success of Estonia should imply that it would be included in the first wave of EU enlargement (see below). Meanwhile, the EU has been reluctant to pin down any guarantees or commitments, indicating that it would be premature to offer an exact timetable at this stage. Furthermore, while the EU has stated a preference for dealing with the Baltics as a single entity, differences in the pace of the transition process and implementation of economic and political reforms among the three countries implied that the EU would have to treat each applicant more or less on an individual basis.

In their endeavor to become members of the EU, the focus of the associated countries of central and eastern Europe has been on the outcome of the Intergovernmental Conference (IGC), a conference of representatives of the governments of the EU member states. One of the main tasks of the IGC, which got under way in March of 1996, was to decide on the eastern enlargement of the EU, a process that includes a major review of the current institutions and decision-making procedures of the EU. In the end, the outcome of the Intergovernmental Conference, together with the economic development and legal progress of the associated countries, had a decisive influence on the time frame and conditions of the membership negotiations.

To determine with which associated countries to initiate the first wave of membership negotiations for its eastern enlargement, the EU asked all prospective members in central and eastern Europe to fill out an extensive questionnaire; the 300,000 pages of answers by the associated nations were subsequently examined by the EU ahead of the June 1997 Amsterdam summit. Following the summit, the European Commission presented a package known as “Agenda 2000,” comprising four key sets of documents on enlargement, which set out (1) the Commission's view on individual countries' applications; (2) an evaluation of the impact of enlargement on EU policies, notably on the Common Agricultural Policy and the regional funds; (3) a draft budget to run from 2000 taking into account the prospect of enlargement; and (4) a composite paper bringing together the Commission's overall analysis of the applicant's readiness for membership and the likely impact on the EU.9 In particular, the Commission recommended that the central and eastern European associated member countries to be included in the first wave of membership negotiations should be, in alphabetical order, the Czech Republic, Estonia, Hungary, Poland, and Slovenia; in addition, it was recommended that membership negotiations also be initiated with Cyprus.

A final decision regarding the timetable of the Eastern enlargement was taken at the EU Luxembourg summit in December last year, indicating that while full accession talks, that is, bilateral negotiations at the government level, will be initiated in April this year with the six countries suggested by the European Commission, preparatory talks will begin at the same time with the remaining central and eastern European applicant countries, that is, Bulgaria, Latvia, Lithuania, Romania, and Slovakia. The enlargement process will officially begin on March 30, 1998, with a meeting of foreign ministers from the 15 EU member nations and from the 11 applicant countries. All 11 countries will be offered “pre-accession partnerships,” including financial aid and annual reviews to determine whether new countries should join the negotiations. The six “first wave” countries will also be invited to an intergovernmental conference, with the eventual aim of signing accession agreements; actual EU membership for the first associated member countries is, however, not expected to take place until 2002 at the earliest, and most likely not until 2004-05.10

As mentioned, the exact timing of EU accession for the three Baltic countries will in the end depend on both the EU's willingness and capacity to absorb new members and the status of the economic, political, social, and legal reform processes in the three countries. In that context, it is worthwhile noting that while the White Paper is encouraging in its detailed step-by-step advice, it clearly highlights the enormous amount of work yet to be completed. The EU legal framework needs to be translated into each country's own language and domestic laws need to be approximated to EU legislation.11 The next section will review the EU accession criteria as well as the Maastricht criteria for participation in the European Monetary Union (EMU) and the status of the Baltic countries in this regard, examining both the progress achieved so far as well as the areas where further measures will be needed.

EU Membership and Implications for Economic Policy in the Baltics

With the Baltics still in transition, and with their economic, political, and social systems still forming, the terms of admission into the EU and the problem of defining the admission criteria have become contentious. This section will review the economic and sociopolitical situation of the Baltic countries, both regarding progress made in the last years toward meeting the EU accession criteria and areas in which further efforts are still needed. Progress will be discussed both in terms of a number of “transition” indicators as defined by the EBRD and in terms of the socioeconomic variables included in the “French” list of admission criteria. Furthermore, having entered the EU, the subsequent question for the Baltics will be adherence to the Maastricht criteria and the timing of EMU participation. Therefore, the Baltics’ current performance vis-à-vis the Maastricht convergence criteria on inflation, state finances, long-term interest rates, and exchange rate stability, and the outlook for eventual Baltic EMU participation are also reviewed.

The Baltics in Transition: EBRD Indicators

In its Transition Reports, the EBRD points out that when discussing the progress made by transition countries in their transformation toward a market economy, “one of the most important lessons is that there can be, and have been, different paths to a market economy, just as there are many forms of the market economy itself.”12 However, at the same time, it acknowledges that “there are important common features of well-functioning market economies and of effective transitions.” Therefore, since 1994, the EBRD has published a number of indicators of progress in market-oriented reform for 25 countries in central and eastern Europe, the Baltics, Russia, and the other countries of the former Soviet Union.13 The indicators try to capture progress in the areas of enterprises, markets and trade, financial institutions, and legal reform. While they cannot capture all dimensions of the transition process, they provide an overview of the relative stages of transition of the different countries. The 1994–97 EBRD transition indicators are presented for the three Baltic countries in Table 7.2. As can be seen from the table, the indicators overlap with some of the measures in the “French” list, including the extent of privatization, the existence of a well-functioning banking system, and the capacity to implement legal reform. The numbers assigned to each indicator represent the general level of transition achieved in a certain area, as assessed by the EBRD, with most advanced industrial economies qualifying for the 4+ rating for most of the indicators (the definitions for the EBRD transition indicators are provided in table 7.3). While the indicators are meant primarily to assess the status of reform rather than the pace of change itself,14table 7.2 also illustrates the progress achieved in the Baltics since 1994. According to the EBRD, the three Baltic countries have now all reached “advanced” stages of transition, in contrast to many of the other transition countries, which still remain at early or intermediate stages of transition.15

Table 7.2.EBRD Transition Indicators1
EstoniaLatviaLithuania
199419951996199719941995199619971994199519961997
Private sector share of GDP in percent (midyear estimate)556570705560606050556570
Large-scale privatization344422333333
Small-scale privatization444+4+34444444
Enterprise restructuring233332233-2233-
Price liberalization3333333333333
Trade and foreign exchange system444444444444
Competition policyn.a.333-n.a.223-n.a.222+
Banking reform and interest rate liberalization3333+33332333
Securities markets and nonbank financial institutionsn.a.223n.a.222+n.a.222+
Extensiveness/effectiveness of legal rules on investment4n.a.344n.a.243n.a.223
Source: EBRD Transition Report, 1994, 1995, 1996, and 1997.

Most advanced industrial economies would qualify for the 4+ rating for almost all transition indicators.

In 1997, governnance and restructuring.

In 1994, price liberalization and competition policy were grouped together.

In 1997, pledge, bankruptcy, and company laws.

Source: EBRD Transition Report, 1994, 1995, 1996, and 1997.

Most advanced industrial economies would qualify for the 4+ rating for almost all transition indicators.

In 1997, governnance and restructuring.

In 1994, price liberalization and competition policy were grouped together.

In 1997, pledge, bankruptcy, and company laws.

Table 7.3.Classification System for the EBRD Transition Indicators
Transition ElementCategoryDescription of the Category
Large-scale privatization1Little private ownership
2Comprehensive scheme almost ready for implementation; some sales completed.
3More than 25 percent of large-scale enterprise assets in private hands or in the process of being privatized (with the process having reached a stage at which the state has effectively ceded its ownership rights), but possibly with major unresolved issues regarding corporate governance.
4More than 50 percent of state-owned enterprise and farm assets in private ownership.
4+Standards and performance typical of advanced industrial economies: more than 75 percent of enterprise assets in private ownership with effective corporate governance.
Small-scale privatization1Little progress
2Substantial share privatized
3Nearly comprehensive program implemented
4Complete privatization of small companies with tradable ownership rights
4+Standards and performance typical of advanced industrial economies: no state ownership of small enterprises; effective tradability of land.
Enterprise restructuring1Soft budget constraints (lax credit and subsidy policies weakening financial discipline at the enterprise level); few other reforms to promote corporate governance.
2Moderately tight credit and subsidy policy but weak enforcement of bankruptcy legislation and little action taken to strengthen competition and corporate governance
3Significant and sustained actions to harden budget constraints and to promote corporate governance effectively (e.g., through privatization combined with tight credit and subsidy policies and enforcement of bankruptcy legislation).
4Substantial improvement in corporate governance, for example, an account of an active corporate control market; significant new investment at the enterprise level.
4+Standards and performance typical of advanced industrial economies: effective corporate control exercised through domestic financial institutions and markets, fostering marketdriven restructuring.
Price liberalization1Most prices formally controlled by the government
2Price controls for several important product categories, state procurement at nonmarket prices remains substantial.
3Substantial progress on price liberalization: state procurement at nonmarket prices largely phased out.
4Comprehensive price liberalization; utility pricing that reflects economic costs.
4+Standards and performance typical of advanced industrial economies: comprehensive price liberalization; efficiency-enhancing regulation of utility pricing.
Trade and foreign exchange system1Widespread import and export controls or very limited legitimate access to foreign exchange.
2Some liberalization of import and/or export controls; almost full current account convertibility in principle but with a foreign exchange regime that is not fully transparent (possibly with multiple exchange rates).
3Removal of almost all quantitative and administrative import and export restrictions; almost full current account convertibility.
4Removal of all quantitative and administrative import and export restrictions (apart from agriculture) and all significant export tariffs; insignificant direct involvement in exports and imports by ministries and state-owned trading companies; no major nonuniformity of customs duties for nonagricultural goods and services; full current account convertibility.
4+Standards and performance norms of advanced industrial economies: removal of most tariff barriers; membership in World Trade Organization (WTO).
Competition policy1No competition legislation and institutions.
2Competition policy legislation and institutions set up; some reduction of entry restrictions or enforcement action on dominant firms.
3Some enforcement actions to reduce abuse of market power and to promote a competitive environment, including break-ups of dominant conglomerates; substantial reduction of entry restrictions.
4Significant enforcement actions to reduce abuse of market power and to promote a competitive environment.
4+Standards and performance typical of advanced industrial economies: effective enforcement of competition policy; unrestricted entry to most markets.
Banking reform and interest rate liberalization1Little progress beyond establishment of a two-tier system.
2Significant liberalization of interest rates and credit allocation; limited use of directed credit or interest rate ceilings.
3Substantial progress in establishment of bank solvency and of a framework for prudential supervision and regulation; full interest rate liberalization with little preferential access to cheap refinancing; significant lending to private enterprises and significant presence of private banks.
4Significant movement of banking laws and regulations toward BIS standards; wellfunctioning banking competition and effective prudential supervision; significant term lending to private enterprises; substantial financial deepening.
4+Standards and performance norms of advanced industrial economies: full convergence of banking laws and regulations with BIS standards; provision of full set of competitive banking services.
Securities markets and nonbank financial institutions1Little progress
2Formation of securities exchanges, market-makers and brokers; some trading in government paper and/or securities; rudimentary legal and regulatory framework for the issuance and trading of securities.
3Substantial issuance of securities by private enterprises; establishment of independent share registries, secure clearance and settlement procedures, and some protection of minority shareholders; emergence of nonbank financial institutions (e.g., investment funds, private insurance and pension funds, leasing companies) and associated regulatory framework.
4Securities laws and regulations approaching international standards; substantial market liquidity and capitalization; well-functioning nonbank financial institutions and effective regulation.
4+Standards and performance norms of advanced industrial economies: full convergence of securities laws and regulations with international standards; fully developed nonbank intermediation.
Extensiveness of legal rules on investment1Legal rules are very limited in scope and impose substantial constraints on creating investment vehicles, security over assets or repatriating profits. Indirect investment is not specifically regulated.
2Legal rules are limited in scope and impose significant constraints on creating investment vehicles, adequate security over assets or repatriating profits.
3Legal rules do not impose major obstacles to creating investment vehicles, security over assets or repatriating profits. However, they are in need of considerable improvement.
4Legal rules do not discriminate between foreign and domestic investors and impose few restrictions on creating a range of investment vehicles and security instruments. Indirect investments is specifically regulated.
4+Legal rules closely approximate generally accepted standards internationally and impose few restrictions, including on the creation of sophisticated investment vehicles or security. Indirect investment law is well developed.
Effectiveness of legal rules on investment1Legal rules are usually very unclear and often contradictory and the availability of independent legal advice is very limited. The administration of the law is substantially deficient (e.g., little confidence in the abilities and independence of the courts, no or poorly organized security and land registers).
2Legal rules are generally unclear and sometimes contradictory. Legal advice is often difficult to obtain. The administration and judicial support of the law is rudimentary.
3While legal rules are reasonably clear and ascertainable through legal advice, administration or judicial support of the law is often inadequate (e.g., substantial discretion in the administration of laws, few up-to-date registers).
4The law is reasonably clear and legal advice is readily available. Investment laws are reasonably well administered and supported judicially, although that support is sometimes patchy.
4+The law is clear and readily ascertainable. Sophisticated legal advice is readily available. Investment law is well supported administratively and judicially, particularly regarding the efficient functioning of courts and the orderly and timely registration of proprietary or security interests.
Source: EBRD Transition Report, various issues.
Source: EBRD Transition Report, various issues.

During the 1994–97 period, all three Baltic countries have made progress in privatization. Latvia has been the slowest of the three in large-scale privatization; while only a few of the large state-owned enterprises in Latvia have been privatized, about 30 percent of Lithuania's and virtually all of the medium-sized and large enterprises included in Estonia's 1993–95 privatization program have been privatized. In 1997, Lithuania announced the privatization (through international tenders) of 14 of the largest enterprises in the energy, telecommunications, and transport services. Small companies have been almost completely privatized in the Baltic countries, with Estonia reaching an “industrial-country rating” in this area in 1996; meanwhile, sales of land and real estate remain more problematic. Estonia and Lithuania now have private sector shares of GDP of some 70 percent compared with an estimated 60 percent share for Latvia.16

Corporate restructuring is moving along in all three countries, with Latvia and Lithuania again treading in Estonia's footsteps. Through privatization efforts, tight credit policy, cutback in subsidies, and strict enforcement of bankruptcy legislation, Estonia has strived to constrain budgets and promote responsible corporate management. Meanwhile, the other two Baltic countries have pursued more moderate credit and subsidy policies. Further improvements in corporate management and in financial discipline at the enterprise level are still needed throughout the Baltics, preferably accompanied by further actions to break up the dominance of key state-owned firms.

All Baltic countries have made significant gains in price and trade liberalization. Few prices are formally under government control, even though complete price liberalization is yet to be achieved. As discussed in Section II, Estonia is in a unique position regarding trade liberalization with one of the most liberal trade regimes in the region. Latvia and Lithuania have removed most quantitative and administrative import and export restrictions, as well as all significant export tariffs, while average import tariffs on raw materials, intermediate goods, and industrial products are generally moderate.

The significant openness of the trade regimes in the Baltics may in fact prove contentious ahead of the upcoming EU accession negotiations. Remaining tariff barriers in the Baltics may, on the one hand, be lowered even further in connection with the ongoing bilateral negotiations to join the WTO, a prerequisite for EU membership. On the other hand, once a member of the EU, each country will have to raise its external trade tariffs to the common EU level, which is in some cases above the levels currently prevailing in the Baltics. It should also be noted that the Association Agreements between the Baltics and the EU, which entered into force early this year, do not allow the Baltic countries to impose any new tariffs on imports from the EU.

In Estonia, significant enforcement actions have been taken to reduce abuse of market power and promote a competitive environment, including breakups of dominant conglomerates and a substantial reduction in entry restrictions; the country is setting up competition legislation and institutional oversight. Latvia and Lithuania have embarked on similar undertakings, although further efforts are still needed; to reach the level of advanced industrial countries, competition policy and market access will have to be further improved in both countries, in particular in Lithuania.

Banking reform and interest rate liberalization have proceeded at approximately the same pace in all three countries. Interest rates and credit allocation have been liberalized, and progress has been made in the establishment of bank solvency requirements and frameworks for advisory supervision and regulation. Banking sector reforms where more progress is needed include lending to private enterprises and bank privatization. Also, the Baltics still do not provide the full range of competitive banking services available elsewhere in Europe, and further progress is required toward full convergence of banking laws and regulations with the Bank of International Settlement standards.

The development of securities markets and nonbank financial institutions has been rather slow in all three countries. It will be necessary to further develop the legal and regulatory framework to promote the issuance and trading of securities of private enterprises. Furthermore, laws and regulations need to be harmonized with international standards; an independent share register and secure clearing and settlement procedures need to be established; and the rights of minority shareholders need to be protected. Steps should be taken to foster growth and supervision of nonbank financial institutions, such as investment funds, private insurance and pension funds, and leasing companies.

Estonia has also been ahead of the other two Baltic countries regarding investment legislation. Legal rules do not impose major obstacles to the creation of investment opportunities or remittance of profits. The law is reasonably clear in this regard, with legal advice readily available if needed. The judicial and administrative support of the laws are, however, still incomplete. In Latvia and Lithuania, progress has been made to expand and enhance the effectiveness of the legal framework on investment; however, legal rules are not always clear and expert advice can be difficult to obtain. The laws are also less conducive to creating investment vehicles and the judicial and administrative support of the laws need to be further developed. Further efforts should therefore concentrate on bringing the legal framework in line with international standards and on creating a functional court system. In both countries, the governments are committed to these goals, in particular in Lithuania in the context of a significantly intensified privatization campaign.

The French List: Status of the Baltic Countries

As discussed in Section II, a more detailed description of the admission criteria, generally known as the “French list,” was proposed during the Copenhagen summit to provide more concrete definitions and guidelines on what is expected of the associated countries. Some of the measures listed in the French list were already included among the EBRD transition indicators, as shown earlier. Selective economic variables as proposed by the French list are displayed for the Baltic countries for the past four years in Table 7.4. These variables include GDP per capita (in U.S. dollars), meant to capture the general state of development; real GDP growth and foreign direct investment, indicative of potential future progress; inflation; the fiscal balance in terms of GDP, measuring the stance of fiscal policy; the ratio of public debt to GDP; the exchange rate vis-à-vis the U.S. dollar and the deutsche mark, reflecting the stability of monetary policy; and total exports in terms of GDP, gauging the economies’ degree of openness.

Table 7.4.Selected Economic Accession Indicators for the Baltics
EstoniaLatviaLithuania
Variable199419951996199719941995199619971994199519961997
GDP per capita (U.S. dollars)1,5552,4332,9593,2101,4301,8802,1452,3251,1311,6222,1282,575
Real GDP growth (percent)-1.84.34.010.82.10.33.36.5-9.83.34.75.7
Foreign direct investment, net
In millions of U.S. dollars2122021101321552443764153172152328
In percent of GDP9.15.62.52.84.25.27.07.20.71.21.93.4
Inflation (percent)
Period average4829231136251887240259
End of period422915326231374536138
General government
Financial balance (percent of GDP)2.8-0.9-1.52.0-1.7-2.7-1.21.6-1.2-2.6-2.5-0.8
Fiscal balance (percent of GDP)1.3-1.2-1.52.0-4.0-3.3-1.31.3-4.8-4.5-4.6-1.9
Public debt (percent of GDP)7.36.76.95.614.615.314.211.215.318.223.421.2
Local currency (period average) versus
U.S. dollar12.9911.4712.0314.100.5600.5280.5510.5814.004.004.004.00
Deutsche mark8.008.008.008.000.3450.3680.3660.3352.462.792.662.31
Exports in percent of GDP1626253573436363747454545
Sources: IMF, International Financial Statistics; national authorities; and IMF staff estimates.

Merchandise exports and net services balance.

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

Merchandise exports and net services balance.

While the Baltics are still clearly lagging behind as to per capita incomes compared with average industrial country levels (see Table 7.4), the current level of income should be less of a concern ahead of EU membership negotiations. More important will be the EU's assessment of the countries’ ability to create wealth fast enough to bring them up to EU standards in a reasonably short time. The Baltics will therefore have to convince the EU that they will exceed the EU average growth rate in the years to come. From Table 7.4 and Table 7.5, which lists some basic economic indicators for the Baltics and the EU for the 1994–96 period, we see that starting in 1996, the three Baltic countries all grew at least as fast as, or even faster than, the estimated EU growth rates. However, real growth rates of 6–11 percent are estimated to be necessary to reach the per capita income level of even the least wealthy EU member states by 2010.17

Table 7.5.Selected Economic Indicators for the Baltics and the EU1
BalticsEuropean Union
Variable199419951996199419951996
Real GDP growth (percent)-3.72.34.03.02.51.8
Inflation (average; percent)5231223.13.12.4
Inflation (end of period; percent)3829142.2
Fiscal balance (percent of GDP)2-2.5-3.0-2.5-5.1-5.0
Public debt (percent of GDP)212.413.414.760.164.3
Memorandum item
Baltic exports in percent of EU exports30.250.290.36
Sources: Eurostatistics; IMF, International Financial Statistics; national authorities; and IMF staff estimates.

Referring to the 15 EU member states.

Central government for the EU.

Merchandise exports.

Sources: Eurostatistics; IMF, International Financial Statistics; national authorities; and IMF staff estimates.

Referring to the 15 EU member states.

Central government for the EU.

Merchandise exports.

In the years to come, investment and the policies that promote it are key to maintaining rapid growth in transition economies.18 Given the lack of domestic saving in the Baltics, foreign investment is particularly important. However, foreign direct investment has so far been quite moderate and volatile; while Estonia reached a peak in 1994 with foreign direct investment inflows amounting to 9 percent of GDP, inflows dropped to only 2.5 percent of GDP in 1996.19 Inflows to Latvia have in recent years amounted to 5–7 percent of GDP. Lithuania has generally been less successful, attracting only about 2 percent of GDP in foreign inflows in 1996 although foreign direct investment is estimated to have reached 4 percent of GDP in 1997. In light of the preceding discussion concerning the high growth rates required to catch up with average EU income levels, and the important role played by FDI in the modernization of transition economies, the Baltics will need to continue to strive to maintain a favorable investment climate, including through the elimination of remaining restrictions to foreign participation in domestic economic activity.

The remaining variables in Table 7.4 show a mixed picture. Despite substantial progress in the past years, the rates of inflation in the Baltics are still significantly above the currently very low EU average; meanwhile, variables measuring the fiscal stance, such as deficit and debt ratios, indicate a notably better position compared with that of the EU (Table 7.5). Furthermore, exchange rates have been stable, reflecting the fixed exchange rate regimes of all three Baltic countries and the degree of openness of their economies. High export growth will also be important to ensure high economic growth, as investments in physical capital primarily will have to come through imported machinery. To capture some of the impact of the prospective member countries’ economies on the EU, the ratio of Baltic exports to EU exports is also provided in Table 7.5, clearly highlighting the Baltics’ relatively minor impact on EU trade flows.

The remaining indicators included in the French list refer to the convertibility of the local currency and policies on capital movements, the level of social protection, and the existence of a modern fiscal system. All three Baltic countries have liberalized their capital accounts, and they all accepted the obligations of the IMF's Article VIII in mid-1994. More work is needed, however, in the areas of social protection and public sector reform, and further efforts within the Phare Programs will in fact be focused on, inter alia, social sector development and public sector management.

The Maastricht Criteria: Status of the Baltic Countries

The first step toward the EU for the associated member countries of central and eastern Europe is to meet the economic, social, and legal requirements for membership.20 Among the requirements defined in the Copenhagen Council is the existence of a functioning market economy capable of coping with competitive pressures and market forces within the Union as well as the ability to take on the obligations of membership including the adherence to the aims of EMU. If an associated member country does not meet the Maastricht criteria for EMU participation by the time of EU membership, it will have to adopt the general goals and provisions of the third stage of EMU as a member state with a derogation.21 This derogation is to be temporary, lasting only until the member state meets the convergence criteria, at which point, according to the EU interpretation,22 it is obliged to participate in the third stage of EMU encompassing the (irrevocable) fixing of parities between the currencies of the qualifying EU member states.23

The Maastricht convergence criteria state that to qualify for the EMU, which is to start on January 1, 1999, the following criteria will have to have been met in 1997:

  • the rate of inflation cannot be more than 1½ percentage points above the average of the three best-performing member states;

  • long-term interest rates cannot be more than 2 percentage points above the same benchmark;

  • the budget deficit cannot exceed 3 percent of GDP, unless this ratio has declined “substantially and continuously,” or the excess over the reference value is “exceptional and temporary”;

  • public debt cannot exceed 60 percent of GDP, unless the ratio is diminishing “sufficiently” and approaching the reference value at a “satisfactory pace”; and

  • the exchange rate should have observed the “normal margins” of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) for the two preceding years.

From the above list of convergence criteria and from the discussion above, it is clear that the Baltic countries would have little problem today qualifying for the two fiscal criteria; both public debt and fiscal deficits are well below the stipulated levels, in part reflecting the fact that all debt of the former Soviet Union was assigned to Russia by the time of the breakup.24 Furthermore, the pegged exchange rate regimes chosen by the Baltic countries during their transitions from planned to market economies bode well for their ability to participate in a fixed exchange rate regime centered around the forthcoming “euro.”25

Meanwhile, more efforts will be needed regarding the other two financial variables. Inflation in the Baltics is still significantly above the EU average, not to say above the rates of inflation of the “best-performing” states.26 Even more complex is the issue of long-term interest rates. The Baltic countries, just as the other associated member countries in central and eastern Europe, are still in transition to market economies, with highly underdeveloped long-term capital markets; for example, ten-year bond yields, the maturity considered for the convergence criteria, do not yet exist in the Baltic countries. Therefore, the development of financial markets will be a prerequisite for assessing the performance of the Baltics regarding the criterion on interest rate stability. In fact, the absence of developed financial markets in the transitional economies is a symptom of their un-readiness for EMU participation at this stage.

A couple of final caveats may be necessary. First, it should be noted that the Maastricht convergence criteria for EMU participation have to be fulfilled not only by the time a country enters into the third stage but also subsequently on a permanent basis. Therefore, the ability to correct macroeconomic distortions by policies compatible with market economies and EU rules will be as important as the magnitude of the distortions per se. Second, when deciding at which stage to adopt the EMU convergence criteria, the associated member countries should take into account the notion that a premature adoption of excessively tight convergence criteria could slow down the successful completion of necessary structural reforms.

Conclusions

The intention of the Baltics to accede to the EU may have implications for their relations with the IMF. Given the Baltics’ explicit desire for closer integration with Europe in general and the EU in particular, a standpoint that probably can be attributed not only to economic arguments but also to geopolitical considerations, it may well be that preparations for accession, such as the approximation of domestic laws to the internal market's acquis communautaire, may absorb a large share of already scarce human resources and put strains on domestic administrative capacities. In that context, it is worthwhile noting that, notwithstanding plans to accede to the EU, both Estonia and Latvia have found it advantageous to negotiate programs with the IMF, providing, inter alia, policy advice and precautionary financing. Following the successful expiration in 1997 of its first arrangement under the Extended Fund Facility (EFF), Lithuania at this time does not envisage another program with the Fund. Overall, the measures expected to be undertaken by the Baltics to become members of the EU should be broadly in line with IMF policies, even though there may, at times, be differences of view as regards priorities and the timing of implementation. One such area is trade policy, where the IMF's general advice of lowering tariffs and reducing protection may run counter to EU advice ahead of accession negotiations.

See Commission of the European Communities (1994a, p.1) and also (1994b,1995b, and 1996f).

In addition to the Europe Agreements signed between the EU and the ten countries of central and eastern Europe, EU Association Agreements with Malta and Cyprus came into force already in 1971 and 1973, respectively. See Commission of the European Communities (1993a and 1993b).

PHARE, which now encompasses all the central and eastern European associated member countries, is an acronym for “Poland and Hungary: Aid for Restructuring of Economies.”

In addition to the ten central and eastern European countries with which the EU has signed Europe Agreements, the Phare Program also includes Albania.

See Commission of the European Communities (1996d and 1996e).

In addition, the Baltics received ECU 15 million in 1991 through the TACIS (“Technical Assistance to the Commonwealth of Independent States”) program which was designed to promote the development of the newly independent states of the former Soviet Union.

See Commission of the European Communities (1995a)..

See Commission of the European Communities (1997b).

See, for example, Backé (1997) for a discussion on the first wave of eastern EU enlargement.

For example, some 400 directives reportedly must be introduced before the end of 1999 to align Latvian legislation with the EU standards while, as of mid-1997, Estonia's laws still needed to be aligned with at least 1,000 EU directives, an undertaking that is estimated to cost some EEK 400 million.

EBRD (1996), p. 2.

See EBRD (1997).

For instance, Slovenia's 4+ rating on small-scale privatization despite the lack of a comprehensive privatization program reflects the fact that small-scale activity in Slovenia was largely private before the transition began.

Similarly, Croatia, the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia, that is, the majority of the associated EU member countries of central and eastern Europe, are classified as advanced transition countries.

By comparison, on average more than 75 percent of enterprises in advanced industrial countries are in private hands.

See, for example, Federation of Swedish Industries (1996).

See, for example, Fischer, Sahay, and Végh (1996a and 1996b) for a discussion of the growth prospects of transition economies.

The drop in foreign direct investment to Estonia in 1996 can in part be attributed to a decline in investment opportunities in between the completion of sales of small and medium-sized public enterprises and the privatization of larger state enterprises and infrastructure enterprises. However, the decline may also be attributed to a shift in foreign capital inflows to portfolio investments.

Other steps toward the EU include decisions on whether to accede to the EU's Social Charter; Latvia recently signed the Social Charter and Estonia is preparing such a step.

See Ilzkovitz (1996) for a good overview of the challenges facing the associated member countries ahead of EMU participation.

Individual countries have at times expressed differing interpretations regarding their obligation to participate in the EMU by the time they meet the Maastricht convergence criteria, suggesting that they could “opt out” of this arrangement.

The derogation of a member state can be abrogated according to a procedure similar to the one employed to decide which member countries will participate in the first round of EMU. This procedure will take place at least every two years, or at the request of the member country with a derogation.

In fact, in the Baltics, to the degree that a gradual increase in public debt would reflect the undertaking of sound investment projects, such a development would not necessarily be unwelcome.

It should be noted that according to the EC Treaty, a two-year formal membership participation in the ERM, without initiating a devaluation, is required to fulfill the exchange rate stability criterion; incidentally, this interpretation is not shared by all current EU member states. In fact, the behavior of the euro is likely to be highly dominated by the current behavior of the deutsche mark, the anchor of the Estonian currency board and one of the five composite currencies constituting the SDR, the anchor of the Latvian fixed exchange rate regime.

Several EU member states currently have rates of inflation below 2 percent.

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