1. Introduction

Reflecting the radical economic reforms that have been undertaken, Estonia has been a significant importer of capital—mostly in the form of foreign direct investment (FDI)—since 1993. It is broadly considered that these inflows have been responding to the exceptional incentives provided to the traded goods sector by the rate at which the domestic currency, the kroon, was pegged to the deutsche mark as well as the potential for rapid productivity increases. Nonetheless, one issue—prompted by the slower than anticipated deceleration in the inflation rate—has been whether these inflows have added to demand for nontraded goods and services, thus exacerbating inflationary pressures.

More recently, the composition of capital inflows has changed, with the share of bank borrowing abroad and portfolio investment flows in financing the current account deficit increasing. This is a trend that seems set to continue in the coming months and has raised questions about: (i) the impact that the on-lending of these flows may have in fueling inflation; (ii) domestic banks’ ability to screen projects in the face of rapid credit growth; and (iii) the sustainability of these inflows.

Identifying the causes and effects of capital inflows is crucial in the Estonian context. The currency board arrangement limits the number of instruments at the disposal of the authorities in coping with these inflows. The response to capital inflows is complete unsterilized intervention, with mainly fiscal adjustment providing room for maneuver. Identifying the causes of these inflows and the impact that they are having is, however, complicated. With the exchange rate fixed and the capital account fully liberalized, developments in interest rates cannot depart significantly from those in the country of pegging, and capital flows respond to increased demand for money. While it is generally accepted that capital inflows responding to an increase in domestic money demand do not have an inflationary impact and so do not present a major problem, in Estonia, and more generally during a process of stabilization and economic transition, it is difficult to ascertain the extent to which the demand for money has indeed increased.

This chapter assesses the causes and effects of capital inflows in Estonia. Section 2 begins by looking at the composition of the flows. Sections 3 and 4 look respectively at the determinants of the flows and the impact they have had. Section 5 draws some conclusions.

2. The composition of capital inflows

The composition of capital inflows can provide evidence of their likely effect on the economy. Capital inflows made up largely of FDI, depending on the use to which they are put ¹/ can be highly beneficial, contributing to a durable increase in economic growth through the transfer of technology, knowhow and resources. While large magnitudes of such inflows can also add to aggregate demand pressures, they generally also reflect confidence in the macroeconomic policies that are being pursued and tend to respond to improved productivity potential. ²/ Conversely, more liquid, and often short-term, inflows tend to respond to external influences (such as low foreign interest rates) as much as domestic influences. To the extent that such capital inflows are responding to domestic influences, they may respond to, for example, an inappropriate fiscal and monetary policy mix which is keeping domestic interest rates high and (or) bandwagon effects.

A close look at Estonia’s external capital account during the 1993-95 period shows two distinct trends (Table 15). First, FDI flows since 1993 have been at very high levels. In both 1994 and 1995, for example, FDI inflows were more than sufficient to cover the large current account deficits—7.5 percent and 5.3 percent, respectively—that emerged. Second, Estonia was a net exporter of other forms of private capital—and in particular short-term capital—in the initial period of stabilization (1992-94). Since mid-1995, however, this trend has reversed and significant amounts of financial capital have been imported. Interestingly, the errors and omissions item of the balance of payments indicates an outflow of US$50 million in 1993 (amounting to some 2.7 percent of GDP), but it also shows cumulative inflows of a similar magnitude in 1994 and 1995. ³/

The magnitude of FDI in Estonia since the country started implementing its far reaching stabilization and economic reform program in 1992 has been quite considerable. By some accounts, between 1993 and 1995, Estonia received more per capita FDI than any of the transition economies of Eastern Europe and the former Soviet Union. More generally, the level of FDI in Estonia has been above or comparable with that typically experienced by rapidly growing economies such as China, Thailand and Malaysia (Table 16). In some respects, this is a reflection of the small size of Estonia’s economy: a few large projects bound to have a noticeable presence. Nonetheless, the fact that this high level of investment has been sustained for four years, implies that these inflows are responding to the reforms which have increased the return on capital. The composition of FDI itself has changed. From 1992 to 1994, the lion’s share of FDI was in the form of equity investment in enterprises. In 1995, however, the share of capital being reinvested and investment in the form of loans in total FDI was broadly equal to that from new equity investment. Arguably, this reflects the easing of credit constraints on local enterprises.

Table 15.

Estonia: Financial and Capital Account, 1992–95

Sources: Bank of Estonia; and Fund staff estimates.

Table 15.

Estonia: Financial and Capital Account, 1992–95

				1992	1993	1994	1995	1992	1993	1994	1995
					(In millions of U.S. dollars)			(Ratio to GDP)
Trade Balance				-90.1	-144.8	-361.3	-692.1	-8.6	-8.8	-15.8	-19.7
Current account balance				35.7	23.3	-171.0	-185.2	3.4	1.4	-7.5	-5.3
Capital and financial account				52.2	222.2	175.2	258.9	5.0	13.5	7.6	7.4
	Foreign direct investment			79.9	154.4	212.2	202.3	7.6	9.4	9.3	5.8
		Equity		65.2	92.8	142.1	102.3	6.2	5.7	6.2	2.9
		Reinvestment		9.2	27.6	42.8	15.4	0.9	1.7	1.9	0.4
		Other		5.5	34.0	27.3	84.6	0.5	2.1	1.2	2.4
	Portfolio investment			—	-0.2	-14.1	-16.3	—	—	-0.6	-0.5
	Other long term			9.6	84.4	7.3	47.6	0.9	5.1	0.3	1.4
		Public		10.9	66.0	28.8	55.2	1.0	4.0	1.3	1.6
		Private		-1.3	18.4	-21.5	-7.6	-0.1	1.1	-0.9	-0.2
	Short–term			-26.5	-82.5	-39.9	27.0	-2.5	-5.0	-1.7	0.8
		Public		0.4	-17.0	0.4	-0.4	—	-1.0	—	—
		Commercial banks		-41.1	-36.8	-69.4	41.2	-3.9	-2.2	-3.0	1.2
			Assets	-49.3	-44.0	-99.7	-41.1	-4.7	-2.7	-4.3	-1.2
			Liabilities	8.2	7.2	30.3	82.2	0.8	0.4	1.3	2.3
		Private (non-bank)		14.3	-28.6	29.1	-13.7	1.4	-1.7	1.3	-0.4
	Bank of Estonia			-38.0	66.1	10.4	-0.8	-3.6	4.0	0.5	—
		Use of Fund credit		26.4	46.2	—	12.5	2.5	2.8	—	0.4
			Other	-64.3	19.9	10.4	-13.4	-6.1	1.2	0.5	-0.4
Errors & Omissions				-5.6	-50.9	26.4	31.8	-0.5	-3.1	1.2	0.9

Sources: Bank of Estonia; and Fund staff estimates.

View Table

Table 15.

Estonia: Financial and Capital Account, 1992–95

				1992	1993	1994	1995	1992	1993	1994	1995
					(In millions of U.S. dollars)			(Ratio to GDP)
Trade Balance				-90.1	-144.8	-361.3	-692.1	-8.6	-8.8	-15.8	-19.7
Current account balance				35.7	23.3	-171.0	-185.2	3.4	1.4	-7.5	-5.3
Capital and financial account				52.2	222.2	175.2	258.9	5.0	13.5	7.6	7.4
	Foreign direct investment			79.9	154.4	212.2	202.3	7.6	9.4	9.3	5.8
		Equity		65.2	92.8	142.1	102.3	6.2	5.7	6.2	2.9
		Reinvestment		9.2	27.6	42.8	15.4	0.9	1.7	1.9	0.4
		Other		5.5	34.0	27.3	84.6	0.5	2.1	1.2	2.4
	Portfolio investment			—	-0.2	-14.1	-16.3	—	—	-0.6	-0.5
	Other long term			9.6	84.4	7.3	47.6	0.9	5.1	0.3	1.4
		Public		10.9	66.0	28.8	55.2	1.0	4.0	1.3	1.6
		Private		-1.3	18.4	-21.5	-7.6	-0.1	1.1	-0.9	-0.2
	Short–term			-26.5	-82.5	-39.9	27.0	-2.5	-5.0	-1.7	0.8
		Public		0.4	-17.0	0.4	-0.4	—	-1.0	—	—
		Commercial banks		-41.1	-36.8	-69.4	41.2	-3.9	-2.2	-3.0	1.2
			Assets	-49.3	-44.0	-99.7	-41.1	-4.7	-2.7	-4.3	-1.2
			Liabilities	8.2	7.2	30.3	82.2	0.8	0.4	1.3	2.3
		Private (non-bank)		14.3	-28.6	29.1	-13.7	1.4	-1.7	1.3	-0.4
	Bank of Estonia			-38.0	66.1	10.4	-0.8	-3.6	4.0	0.5	—
		Use of Fund credit		26.4	46.2	—	12.5	2.5	2.8	—	0.4
			Other	-64.3	19.9	10.4	-13.4	-6.1	1.2	0.5	-0.4
Errors & Omissions				-5.6	-50.9	26.4	31.8	-0.5	-3.1	1.2	0.9

Sources: Bank of Estonia; and Fund staff estimates.

Table 16.

Ratio of FDI to GDP for Selected Countries, 1989–95

(In Percent)

Sources: IMF World Economic Outlook database; and Fund staff estimates.

Table 16.

Ratio of FDI to GDP for Selected Countries, 1989–95

(In Percent)

	1989	1990	1991	1992	1993	1994	1995
Estonia	…	…	…	7.6	9.4	9.3	5.8
Latvia	…	…	…	3.2	2.4	4.2	3.5
Lithuania	…	…	…	0.5	4.1	3.3	1.9
Czech Republic	0.3	0.3	1.1	3.5	1.8	2.1	5.3
Hungary	0.6	0.9	4.4	4.0	6.1	2.7	9.4
Poland	0.1	—	0.2	0.3	0.7	0.6	0.8
Russia	—	-0.1	—	0.9	0.6	0.2	0.3
Chile	4.5	0.8	1.3	0.8	0.8	1.2	1.9
China	0.6	0.7	0.9	1.5	3.9	6.1	5.4
Indonesia	0.7	1.1	1.2	1.2	1.2	1.4	2.5
Malaysia	4.4	5.5	6.0	5.0	5.2	3.5	4.7
Singapore	6.9	9.5	8.8	2.1	5.7	4.9	5.5
Thailand	2.4	2.6	1.4	1.4	1.0	0.4	0.5

Sources: IMF World Economic Outlook database; and Fund staff estimates.

View Table

Table 16.

Ratio of FDI to GDP for Selected Countries, 1989–95

(In Percent)

	1989	1990	1991	1992	1993	1994	1995
Estonia	…	…	…	7.6	9.4	9.3	5.8
Latvia	…	…	…	3.2	2.4	4.2	3.5
Lithuania	…	…	…	0.5	4.1	3.3	1.9
Czech Republic	0.3	0.3	1.1	3.5	1.8	2.1	5.3
Hungary	0.6	0.9	4.4	4.0	6.1	2.7	9.4
Poland	0.1	—	0.2	0.3	0.7	0.6	0.8
Russia	—	-0.1	—	0.9	0.6	0.2	0.3
Chile	4.5	0.8	1.3	0.8	0.8	1.2	1.9
China	0.6	0.7	0.9	1.5	3.9	6.1	5.4
Indonesia	0.7	1.1	1.2	1.2	1.2	1.4	2.5
Malaysia	4.4	5.5	6.0	5.0	5.2	3.5	4.7
Singapore	6.9	9.5	8.8	2.1	5.7	4.9	5.5
Thailand	2.4	2.6	1.4	1.4	1.0	0.4	0.5

Sources: IMF World Economic Outlook database; and Fund staff estimates.

Other long-term capital flows in Estonia have largely been to the public sector. Government borrowing from official sources contributed to the large overall balance of payments surplus registered in 1993 and was a source of financing the current account deficits in 1994 and 1995. There is no discernable trend in long-term flows to the private sector. This item along with portfolio investment flows has in general played a minor role in the balance of payments so far.

Short-term capital flow developments have been dominated by changes in commercial banks’ net foreign asset position. The balance of payments data indicate that banks increased their gross foreign asset position between 1992 and 1994. This was also the case in 1995; however, foreign liabilities increased by a larger amount that year, with the effect that there was a net inflow of capital intermediated by banks for the first time since 1992 (Table 15).

3. The determinants of capital flows

Estonia’s experience with capital flows points to the presence of asymmetric incentives for capital in the early stages of transition, with high expected returns for FDI and lower returns for financial assets (mainly bank deposits). Since high returns on capital investment were also available for domestic investors, it is not obvious why foreigners rather than domestic residents undertook these investments. This section assesses the determinants of first FDI and then financial flows in Estonia by looking at a number of indirect indicators.

a. Foreign direct investment flows

Economic theory suggests two main approaches of the determinants of FDI. ¹/ The first (microeconomic) approach suggests factors such as firms’ desire to internalize rents, keep technology secret, and circumvent trade barriers as motivating FDI. The second (macroeconomic) strand points to factors related to the cost of capital being important, arguing that foreign firms’ access to cheaper credit ensures that they, rather than domestic investors, undertake certain investments. ²/

In Estonia, both sets of factors are likely to have played a role in influencing FDI. On the one hand, in view of the difficulty of assessing creditworthiness and the absence of a legal framework for taking sanctions against defaulters, banks appear to have been reluctant to lend (see below), leading to a liquidity constraint. On the other hand, even in the absence of a liquidity constraint, firms did not have the necessary technological, design and marketing knowhow to exploit the newly created opportunities.

In fact, the concentration of much FDI in Estonia in production for exports suggests that these microeconomic considerations in general—and, in particular, the firms’ desire to maintain or increase market shares—have elicited much of the investment. Given Estonia’s limited market size (population 1.5 million) and its highly liberal trade regime, production for exports rather than for the domestic market is likely to attract investors to the country. Export growth in Estonia since 1992 has been very impressive. Even if the 103 percent growth in local currency terms registered in 1993 represents an increase from a rather low base, the double-digit growth of 1994 and 1995 remains remarkable (Table 17). ¹/ The direction of exports has also changed noticeably, away from declining markets in the states of the FSU to the more stable and competitive ones in Western Europe. Most of the growth in exports has been in manufactured exports. In particular, exports in the machinery and electrical equipment category have increased quite sharply (with growth rates of 123 percent in 1994 and 51 percent in 1995). This largely comprises exports, by mostly foreign owned businesses, of electronic equipment assembled in Estonia under processing agreements.

Another incentive for inflows has been the apparent undervaluation of the real exchange rate relative to its equilibrium level, thus making it easier for foreign companies to outbid domestic investors. The domestic price of tradables was (and still is) below world price levels. The level at which the kroon was initially pegged to the deutsche mark, while being at the then prevailing market exchange rate, thus provided exceptional returns for the tradables sector. It implied a monthly average wage of US$30, about one seventh of the average dollar wage in Poland at the time. ²/ One reason underlying the undervaluation of the exchange rate was the absence of alternative and secure liquid inflation hedges to foreign currency at the time. ³/ With regard to the price of tradables, their initial and continued undervaluation can be explained by the fact that arbitrage only takes place gradually as well as by the nontradable component in the price of tradables. Indeed, evidence that the price of tradables has not yet equalized can be found in the continuing high volume of visitors to Estonia from neighboring Nordic countries for the sole purpose of shopping.

Table 17.

Estonia: Merchandise Exports and Imports, 1992–95

Source: Bank of Estonia.

Table 17.

Estonia: Merchandise Exports and Imports, 1992–95

		1992	1993	1994	1995	1992	1993	1994	1995
		(In millions of Estonian kroons)				(In percent of total)
Exports		5,209.6	10,611.4	17,377.9	21,097.8	100.0	100.0	100.0	100.0
Animal products		533.1	1,112.2	1,169.6	1,617.4	10.2	10.3	6.7	7.7
Vegetable products		48.9	113.3	291.7	261.8	0.9	1.1	1.7	1.2
Animal and vegetable fats and oils		7.0	74.7	80.2	105.7	0.1	0.7	0.5	0.5
Prepared foodstuffs, beverages, spirits, tobacco		279.5	1,138.5	2,069.0	1,480.5	5.4	10.7	11.9	7.0
Mineral products		584.1	807.9	1335.9	1,703.9	11.2	7.6	7.7	8.1
Products of chemical industry		331.1	511.2	1,151.9	1,596.8	6.4	4.8	6.6	7.6
Plastics, rubber, articles thereof		72.3	156.9	319.7	565.7	1.4	1.5	1.8	2.7
Raw hides, skins, leather		97.1	184.5	2183	239.9	1.9	1.7	1.3	1.1
Wood and articles of wood		450.2	791.0	1,627.0	2,487.0	8.6	7.5	9.4	11.8
Pulp, paper, articles thereof		275.1	63.6	144.3	3392	5.3	0.6	0.8	1.6
Textiles and textile articles		719.5	1,307.9	2,333.4	2,851.5	13.8	12.3	13.4	13.5
Footwear, headgear		54.2	130.0	250.5	3053	1.0	1.2	1.4	1.4
Articles of stone, cement, ceramic, class		65.5	203.1	292.5	342.0	1.3	1.9	1.7	1.6
Precious metals and articles		22.0	127.8	67.1	77.3	0.4	12	0.4	0.4
Base metals and articles thereof		682.9	1,119.1	1387.5	1,428.7	13.1	10.5	8.0	6.8
Machinery and mechanical appliances, electrical equipment		290.0	817.8	1,829.5	2,765.5	5.6	7.7	10.5	13.1
Vehicles, aircrafts, vessels		338.8	1,134.2	1,475.1	1,465.8	6.5	10.7	8.5	6.9
Optical, photographic, measuring, checking instruments		53.3	161.2	310.6	253.4	1.0	1.5	1.8	1.2
Arms and ammunition		0.1	5.4	2.0	4.6	—	0.1	—	—
Miscel. manufactured articles		297.6	591.9	9562	1,203.6	5.7	5.6	5.5	5.7
Works of art and antiques		7.3	59.2	65.9	2.1	0.1	0.6	0.4	0.0
Imports		5,130.3	11,920.9	22,553.3	29,384.7	100.0	100.0	100.0	100.0
Animal products		26.9	131.6	445.6	688.3	0.5	1.1	2.0	2.3
Vegetable products		88.9	291.5	581.9	896.4	1.7	2.4	2.6	3.1
Animal and vegetable fats and oils		235	138.8	257.5	3592	0.5	12	1.1	12
Prepared foodstuff, beverages, spirits, tobacco		307.5	1,203.8	2,138.2	2,190.1	6.0	10.1	9.5	7.5
Mineral products		1,437.2	1,877.8	2,969.1	3341.9	28.0	15.8	132	11.4
Products of chemical industry		270.9	7373	1,6212	2334.1	5.3	6.2	72	7.9
Plastics, rubber, articles thereof		119.6	384.0	858.9	13192	2.3	32	3.8	4.5
Raw hides, skins, leather		29.3	79.6	190.4	2293	0.6	0.7	0.8	0.8
Wood and articles of wood		25.4	93.3	300.9	452.0	0.5	0.8	1.3	1.5
Pulp, paper, articles thereof		175.6	244.4	569.7	973.1	3.4	2.1	2.5	3.3
Textiles and textile articles		398.4	1,247.6	2,230.4	3,157.4	7.8	10.5	9.9	10.7
Footwear, headgear		57.4	119.5	3383	382.3	1.1	1.0	1.5	1.3
Articles of stone, cement, ceramic, class		58.3	145.4	393.4	6172	1.1	1.2	1.7	2.1
Precious metals and articles		23.8	622	62.7	82.4	0.5	0.5	0.3	0.3
Base metals and articles thereof		213.9	613.6	1325.0	2,060.6	42	5.1	5.9	7.0
Machinery and mechanical appliances, electrical equipment		958.7	2,1219	4,684.6	6,2793	18.7	17.8	20.8	21.4
Vehicles, aircrafts, vessels		706.6	1,681.4	2,240.5	2324.4	13.8	14.1	9.9	7.9
Optical, photographic, measuring, checking instruments		76.3	286.9	635.4	834.3	1.5	2.4	2.8	2.8
Arms and ammunition		2.6	29.0	37.0	12.1	0.1	02	02	0.0
Miscel. manufactured articles		121.4	346.5	647.4	850.6	2.4	2.9	2.9	2.9
Works of art and antiques		8.1	83.8	25.2	0.2	0.2	0.7	0.1	—
Memorandum items:
Rates of growth in local currency terms		(In percent)
Total exports			103.7	63.8	21.4
	Wood and articles of wood		75.7	105.7	519
	Textiles		81.8	78.4	222
	Machinery		182.0	123.7	512
Total imports			132.4	892	30.3
	Mineral products		30.7	58.1	12.6
	Textiles		213.2	78.8	41.6
	Machinery		121.4	120.7	34.0

Source: Bank of Estonia.

View Table

Table 17.

Estonia: Merchandise Exports and Imports, 1992–95

		1992	1993	1994	1995	1992	1993	1994	1995
		(In millions of Estonian kroons)				(In percent of total)
Exports		5,209.6	10,611.4	17,377.9	21,097.8	100.0	100.0	100.0	100.0
Animal products		533.1	1,112.2	1,169.6	1,617.4	10.2	10.3	6.7	7.7
Vegetable products		48.9	113.3	291.7	261.8	0.9	1.1	1.7	1.2
Animal and vegetable fats and oils		7.0	74.7	80.2	105.7	0.1	0.7	0.5	0.5
Prepared foodstuffs, beverages, spirits, tobacco		279.5	1,138.5	2,069.0	1,480.5	5.4	10.7	11.9	7.0
Mineral products		584.1	807.9	1335.9	1,703.9	11.2	7.6	7.7	8.1
Products of chemical industry		331.1	511.2	1,151.9	1,596.8	6.4	4.8	6.6	7.6
Plastics, rubber, articles thereof		72.3	156.9	319.7	565.7	1.4	1.5	1.8	2.7
Raw hides, skins, leather		97.1	184.5	2183	239.9	1.9	1.7	1.3	1.1
Wood and articles of wood		450.2	791.0	1,627.0	2,487.0	8.6	7.5	9.4	11.8
Pulp, paper, articles thereof		275.1	63.6	144.3	3392	5.3	0.6	0.8	1.6
Textiles and textile articles		719.5	1,307.9	2,333.4	2,851.5	13.8	12.3	13.4	13.5
Footwear, headgear		54.2	130.0	250.5	3053	1.0	1.2	1.4	1.4
Articles of stone, cement, ceramic, class		65.5	203.1	292.5	342.0	1.3	1.9	1.7	1.6
Precious metals and articles		22.0	127.8	67.1	77.3	0.4	12	0.4	0.4
Base metals and articles thereof		682.9	1,119.1	1387.5	1,428.7	13.1	10.5	8.0	6.8
Machinery and mechanical appliances, electrical equipment		290.0	817.8	1,829.5	2,765.5	5.6	7.7	10.5	13.1
Vehicles, aircrafts, vessels		338.8	1,134.2	1,475.1	1,465.8	6.5	10.7	8.5	6.9
Optical, photographic, measuring, checking instruments		53.3	161.2	310.6	253.4	1.0	1.5	1.8	1.2
Arms and ammunition		0.1	5.4	2.0	4.6	—	0.1	—	—
Miscel. manufactured articles		297.6	591.9	9562	1,203.6	5.7	5.6	5.5	5.7
Works of art and antiques		7.3	59.2	65.9	2.1	0.1	0.6	0.4	0.0
Imports		5,130.3	11,920.9	22,553.3	29,384.7	100.0	100.0	100.0	100.0
Animal products		26.9	131.6	445.6	688.3	0.5	1.1	2.0	2.3
Vegetable products		88.9	291.5	581.9	896.4	1.7	2.4	2.6	3.1
Animal and vegetable fats and oils		235	138.8	257.5	3592	0.5	12	1.1	12
Prepared foodstuff, beverages, spirits, tobacco		307.5	1,203.8	2,138.2	2,190.1	6.0	10.1	9.5	7.5
Mineral products		1,437.2	1,877.8	2,969.1	3341.9	28.0	15.8	132	11.4
Products of chemical industry		270.9	7373	1,6212	2334.1	5.3	6.2	72	7.9
Plastics, rubber, articles thereof		119.6	384.0	858.9	13192	2.3	32	3.8	4.5
Raw hides, skins, leather		29.3	79.6	190.4	2293	0.6	0.7	0.8	0.8
Wood and articles of wood		25.4	93.3	300.9	452.0	0.5	0.8	1.3	1.5
Pulp, paper, articles thereof		175.6	244.4	569.7	973.1	3.4	2.1	2.5	3.3
Textiles and textile articles		398.4	1,247.6	2,230.4	3,157.4	7.8	10.5	9.9	10.7
Footwear, headgear		57.4	119.5	3383	382.3	1.1	1.0	1.5	1.3
Articles of stone, cement, ceramic, class		58.3	145.4	393.4	6172	1.1	1.2	1.7	2.1
Precious metals and articles		23.8	622	62.7	82.4	0.5	0.5	0.3	0.3
Base metals and articles thereof		213.9	613.6	1325.0	2,060.6	42	5.1	5.9	7.0
Machinery and mechanical appliances, electrical equipment		958.7	2,1219	4,684.6	6,2793	18.7	17.8	20.8	21.4
Vehicles, aircrafts, vessels		706.6	1,681.4	2,240.5	2324.4	13.8	14.1	9.9	7.9
Optical, photographic, measuring, checking instruments		76.3	286.9	635.4	834.3	1.5	2.4	2.8	2.8
Arms and ammunition		2.6	29.0	37.0	12.1	0.1	02	02	0.0
Miscel. manufactured articles		121.4	346.5	647.4	850.6	2.4	2.9	2.9	2.9
Works of art and antiques		8.1	83.8	25.2	0.2	0.2	0.7	0.1	—
Memorandum items:
Rates of growth in local currency terms		(In percent)
Total exports			103.7	63.8	21.4
	Wood and articles of wood		75.7	105.7	519
	Textiles		81.8	78.4	222
	Machinery		182.0	123.7	512
Total imports			132.4	892	30.3
	Mineral products		30.7	58.1	12.6
	Textiles		213.2	78.8	41.6
	Machinery		121.4	120.7	34.0

Source: Bank of Estonia.

b. Financial flows

Relative to FDI flows, the magnitude of short- and long-term financial flows has been limited (Table 15). Further, long-term capital flows have been dominated by government borrowing from official sources. While some of this official borrowing has been on-lent to private enterprises, these flows are much less likely to have been responding to expected returns. Given that portfolio investment flows have until recently also been negligible, expected returns on financial assets are likely to have primarily affected the resource allocation of domestic banks. As mentioned above, commercial banks steadily increased their foreign assets from late 1992 (Chart 9). The increase in foreign liabilities has, however, been faster since mid-1994, leading to a decline in the ratio of foreign assets to total assets and liabilities. Two factors appear to have induced this shift toward domestic assets by commercial banks: (i) improved confidence in the banking system, and (ii) movements in interest rates.

(1) Information asymmetries

In the flux of the transition period, banks’ ability to lend was constrained by the absence of information on enterprise creditworthiness, of sanctions against defaulting borrowers and, indeed, of long-term deposits. Given the lack of alternative financial instruments, virtually the only way that banks could safely earn interest was by depositing funds abroad. ¹/ More recently, however, banks’ reluctance to lend (hold domestic assets) has declined, with demand for credit from newly established private enterprises increasing. These enterprises, unlike state enterprises that previously accounted for a large share of the demand for credit (Chart 9), tend to have clearer accounting and financial controls systems, making it easier for banks to assess risk. ²/

The increase in banks’ willingness to lend is reflected by the increase in the loan to deposit ratio (Chart 10) which has generally exhibited an increasing trend. A look at the structure of banks’ deposits and loans is also instructive. It is only in recent months that the share of time and savings deposits in total deposits has approached the 20 percent mark. The share of demand deposits in total liabilities has declined from some 81 percent in early 1993 to 64 percent in early 1996 (Chart 10).

(2) The role of interest rates

At first glance, the role of interest rates in explaining the shifts in the composition of banks’ assets is puzzling: (i) real lending rates have generally remained strongly negative; and (ii) spreads (both between local and foreign interest rates and between local deposit and lending rates) have narrowed. These developments make the shift toward domestic assets seem implausible. However, they also mask the underlying adjustment process taking place.

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ESTONIA FOREIGN ASSETS AND LIABILITIES AND COMPOSITION OF BANK CREDIT

Citation: IMF Staff Country Reports 1996, 096; 10.5089/9781451812312.002.A004

Source: Bank of Estonia.

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ESTONIA CREDIT TO DEPOSIT RATIO AND COMPOSITION OF BANKS’ DEPOSITS

Citation: IMF Staff Country Reports 1996, 096; 10.5089/9781451812312.002.A004

Source: Bank of Estonia.

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First, with the capital account fully liberalized and the exchange rate pegged to the deutsche mark, arbitrage should ensure that interest rates differ from those prevailing in Germany only to the extent that there is risk of realignment or default. ¹/ The appreciation of the real exchange rate toward its equilibrium value, however, means that inflation is higher (and will likely remain so for some time) in Estonia than in Germany. Clearly the marginal product of capital is much higher than that implied by real interest rates, as evidenced by the high levels of investment. Negative real interest rates do not seem to have led to a consumption boom. Indirect evidence for this can be found from the continuing increase in the share of savings and time deposits in total deposits (Chart 10). If liquidity in Estonia was as plentiful as suggested by the level of real interest rates, it would probably be accompanied by evidence of liquidity preference away from such deposits toward demand deposits or cash. It is noteworthy that the share of cash in circulation has declined from around 40 percent in 1993 and 1994 to some 35 percent by the first quarter of this year—though, this also reflects financial innovation.

Second, what generally determines banks’ willingness to extend credit is the cost of funds. As can be seen from Chart 11, the spread between lending rates in Estonia and the benchmark DM libor rate, while having declined, remains quite substantial at around 10 percent. Admittedly, the effective cost of the funds borrowed abroad is likely to be higher when account is taken of the premium of 2 to 3 percentage points that Estonian banks typically pay. Even allowing for this, however, the spread between the lending rates in Estonia and the benchmark DM libor rate would still be around 7 percent to 8 percent. This is higher than the margin that banks have if they were to raise the money domestically (Chart 12).

Another factor which may help explain banks’ increasing willingness (ability) to lend may be the lowering of the reserve requirement ratio from 15 percent to 10 percent in 1993 and more generally improvements in the clearing and payments system which necessitate that banks hold less by way of excess reserves. As can be noted in Chart 13, the share of reserves in total assets, which comprises cash in vault, deposits at the Bank of Estonia (BOE) and holdings of BOE certificates of deposits, has steadily declined, being replaced with (higher) income earning assets.²/

4. The impact of the inflows

One concern has been whether the large magnitude of foreign financed investment has increased demand for domestic resources, thus adding to inflationary pressures. This has also applied to the recent increase in capital inflows being intermediated by banks, with the additional concern that it could just as easily reverse. In the context of rapid growth in credit, partly financed by these inflows, another worry has been about banks’ ability to screen marginal projects.

Broadly, these concerns about the inflationary impact of FDI inflows do not appear fully warranted for two reasons: first, the inflows have for the most part served to increase the trade deficit, and so have mostly fallen on imported (machinery and intermediate goods) rather than domestic goods and services. ¹/ Hence, their impact on the price of nontraded goods and services is likely to have been limited.

Second, the FDI inflows appear to have added to aggregate supply more than increased aggregate demand for local goods and services. ²/ Indeed, FDI may have helped stave-off a bigger collapse in output, although direct causal relationship is difficult to establish. At about 35 percent, the cumulative decline in output during the transition period has been lower in Estonia than the other Baltic states and countries of the FSU (except Uzbekistan) (see Chapter I). ³/ It was closer to that experienced in Eastern Europe, where the cumulative decline in output averaged some 28 percent, than in the states of the FSU.

With regard to the impact of financial capital, their relatively small magnitude so far means that their direct impact on the economy and inflation cannot have been dramatic. For the most part, these flows have enabled banks to increase lending. It is estimated that they contributed around a third of the increase in credit growth from 33 percent in March 1995 (year-on-year), to 66 percent in March 1996. The remainder is mainly accounted for by the steady increase in the banks’ capital (Chart 13) and the tendency of banks to reduce the share of assets held as reserves. ¹/ It is noteworthy that even after taking into account the recent inflows, the share of foreign liabilities in total liabilities is quite low at around 10 percent. Much of the credit is extended to private enterprises, though lately credit to individuals has picked up as banks have begun to provide mortgage lending.

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ESTONIA REAL AND NOMINAL INTEREST RATES

Citation: IMF Staff Country Reports 1996, 096; 10.5089/9781451812312.002.A004

Source: Bank of Estonia; IFS.

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ESTONIA INTEREST RATES

Citation: IMF Staff Country Reports 1996, 096; 10.5089/9781451812312.002.A004

Source: Bank of Estonia

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ESTONIA STRUCTURE OF BANKS’ ASSETS AND LIABILITIES

Citation: IMF Staff Country Reports 1996, 096; 10.5089/9781451812312.002.A004

Source: Bank of Estonia.

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The increased lending has generally reflected increased credit demand. As the economic reforms of the past few years have taken hold, they have opened up investment opportunities and the demand for additional working capital has increased. The greater confidence by the public in the banking system, as evidenced by the decline in the share of cash to deposits, and the greater confidence of banks in their borrowers, has enabled the money multiplier to increase (from 1.6 in 1993 to 2.2 in early 1996) generally pointing to financial deepening. The decline in interest rates on bank deposits at the same time that the share of time and savings deposits in broad money has been increasing points to a greater willingness to hold these assets and apparently to an increase in money demand.

More generally, the financial inflows are part of an adjustment mechanism. By enabling money supply to increase, they are validating the relative price adjustment that is taking place (see Chapter II). Thus, concern about their inflationary impact is in some sense misplaced. Nonetheless, while the adjustment of the real exchange rate to its equilibrium level can explain persistent inflation in Estonia, it does not necessarily imply that real interest rates have to be negative. Indeed, in neighboring Lithuania, which also has a currency board arrangement and where the same price adjustment process is taking place, real lending rates are positive and real deposit rates are close to zero. One reason for the different developments in Estonia is that interest rates in Estonia, because of higher confidence in the level of the peg and smaller likelihood of default, have converged faster and are closer to German levels than in Lithuania. Another explanatory factor might be the absence of alternative liquid assets competing with money. There are very limited amounts of bonds in circulation and, until very recently, virtually no equities. Also, unlike in Lithuania, there is no treasury bills markets; as the government has been able to finance expenditure largely through tax revenue, its net position with the banking system has been positive.

5. Conclusion

The recent experience with capital inflows in Estonia, rapid growth in credit, and broader developments, could be seen in the context of the economic booms that seem to follow exchange rate based stabilization strategies. The appreciation of the real exchange rate, increase in real wages, remonetization of the economy, deterioration of the trade and current account witnessed in Estonia are quite similar to the empirical regularities that have been detected following the adoption of the exchange rate as a nominal anchor. ¹/ These booms have often been followed by recessions, the recent Mexican experience being only the latest example. This need not be the fate of the economic recovery in Estonia. An important consideration is that, parallel to stabilization, the transition from the centrally planned to a market economy, and the general liberalization in Estonia have created opportunities for new productive activities that cannot be viewed in incremental terms, as perhaps in other country cases. There is to date little evidence of overheating: there has been no sign of an asset price boom; inflation while still relatively high would seem to be mainly explained by continuing relative price adjustment; the deterioration in trade balance is largely accounted for by imports of capital rather than consumer goods; and capital inflows until recently have been mostly made up of foreign direct investment. While dollar wages have risen substantially, increases in real wages have been more modest, and more in line with the likely improvement in productivity.

While there is no reason to anticipate at this stage any overshooting in the price adjustment mechanism, one should also be reminded that strict adherence to the principles of the currency board arrangement would, of course, trigger an automatic adjustment mechanism to any capital flow- related exogenous or endogenous shocks that Estonia may face. A mixture of domestic unemployment and unsterilized reserve drain would bring about the necessary decline in the domestic price level ensuring that competitiveness is regained. Such reliance on the interest rate mechanism could be costly in terms of output and put severe strains on the banking system. However, the openness of the Estonian economy and the flexibility that appears to characterize so far its goods and labor markets should limit the scope for large disequilibria. In any case, close attention will need to be paid to the maturity structure of banks’ foreign liabilities, and the authorities will need to be ready to use the fiscal and limited banking instruments they have to stay the course.

In sum, capital inflows in Estonia have been beneficial. In fact, they have to be seen as part of the adjustment toward equilibrium of domestic prices. FDI has made up the lions share of the inflows. This should help: first, by integrating Estonia further into the world economy, enabling the country to exploit its comparative advantage and undertake larger and more efficient scale of production; second, through the positive externalities that FDI has. The presence of foreign firms in the domestic market, among other things, will encourage technological diffusion and enhance workforce and managerial skills.