Republic of Estonia: Selected Issues and Statistical Appendix

This Selected Issues paper and Statistical Appendix analyzes the progress made by Estonia since independence. It takes stock of the developments in the banking system and describes how the number of banks in Estonia has been reduced through a series of bankruptcies and mergers from 41 in 1992 to 5 by end 1998. The paper explores nonbank financial sector developments. The paper also describes a composite index of coincidence indicators and tests how well it has tracked recent developments in Estonia.


This Selected Issues paper and Statistical Appendix analyzes the progress made by Estonia since independence. It takes stock of the developments in the banking system and describes how the number of banks in Estonia has been reduced through a series of bankruptcies and mergers from 41 in 1992 to 5 by end 1998. The paper explores nonbank financial sector developments. The paper also describes a composite index of coincidence indicators and tests how well it has tracked recent developments in Estonia.

V. Implications of EU Accession and Participation in EMU72

A. Introduction

79. Estonia attaches high priority to rapid accession to the European Union (EU) and participation in Economic and Monetary Union (EMU). It applied for EU membership in 1995, and was two years later included by the European Council in the first group of countries invited to start membership negotiations together with Cyprus, the Czech Republic, Hungary, Poland, and Slovenia.72 This represented a recognition of Estonia’s efforts toward integrating into the world economy and Western Europe. Estonia’s inclusion in the first group of accession candidates was, in large part, the result of strong macroeconomic and structural policies that had led to major progress in disinflation, external stability, and sustainable growth.

80. Since gaining independence in 1991, Estonia’s economic policies have been anchored in a currency board arrangement and a peg to the deutsche mark, combined with a highly liberal external trade and capital account regime. Estonia has also moved ahead quickly and vigorously in deregulation, price liberalization, and enterprise restructuring and privatization with the objective to establish a market-oriented economy.73 More recently, Estonia has begun to address many of the legal and institutional adjustments required for EU membership. It has been very successful in attracting foreign investors and its trade with Western partners has grown strongly. This can be attributed to Estonia’s strong policy performance, helped by historic ties with Scandinavian countries, a favorable geographic location, a relatively well-developed infrastructure and industrial base, and its well-qualified and still inexpensive labor force.

81. Looking ahead, closer and more formal economic integration with the EU will have benefits and costs for Estonia. For all accession candidates, there is an expectation that the longer term economic gains from joining the EU’s common market will outweigh the related adjustment costs incurred in the transitory period. This view is supported by evidence from countries that joined the EU before the 1990s, with the favorable growth performance of Portugal, Spain, and, especially, Ireland, clearly dominating the less favorable experience of Greece. While these country experiences point to the significance of the domestic policies pursued in earlier years, the integration process had a bearing on their choice of policies. The assumption of a favorable impact of accession is also underpinned by model simulations which suggest a positive real income effect for EU membership candidates from Central and Eastern Europe.74 On the other hand, in addition to the costs related to a reallocation of means of production, further integration with the EU will restrict the scope for discretionary policies given the need for “policy convergence” and the discipline imposed by the Copenhagen criteria (see below), the Maastricht criteria, and the Stability and Growth Pact. Estonia has already lived within such constraints since the currency board leaves limited room for independent monetary and exchange rate policies. Moreover, there are likely to be sizable additional budgetary outlays as well as resource implications from other “adjustment challenges” (EBRD, 1998) which will arise from the need to comply with numerous EU regulations and standards and the requirement for large public sector investments in infrastructure, the environment, and other sectors. In the case of Estonia, which currently has no import tariffs or other trade restrictions, EU accession will also lead to the introduction of tariffs that could divert trade, reduce efficiency, and cause welfare losses.

82. This chapter analyzes the possible macroeconomic benefits and costs resulting from EU membership and EMU participation for Estonia, with particular emphasis on trade and capital flows and fiscal policies. A few caveats are in order as regards the substantive scope and analytical instruments used. First, while projecting future policies and developments is generally difficult and necessarily judgmental, the analysis undertaken is complicated by the fact that many domestic policies are yet to take shape as accession negotiations are still at an early stage. In addition, the policy framework of the EU as well as EMU are both “moving targets;” i.e., they are likely to undergo important changes in the coming years.75 A prominent example in this context is the Common Agricultural Policy (CAP) which may be further reformed before Estonia joins the EU. Second, the net effects of EU accession and EMU participation cannot be well isolated and quantified. Determining the specific impact of the membership scenario as compared to a plausible alternative, or counterfactual, is elusive.76 Third, the analysis is made even more complicated by the fact that Estonia’s economic integration with the EU, and other European countries, is already well underway and set to intensify during the pre-accession period. EU accession and participation in EMU can usefully be interpreted as further stages of an ongoing process.

B. Relations with the EU

83. The conclusion of Association Agreements with Central and Eastern European countries (CEECs) is part of the EU’s pre-accession strategy.77 The ultimate aim is to enable the applicants to prepare for accession, notably by fully accepting the acquis communautaire78 Underlying these agreements is the understanding reached at the European Council in Copenhagen in 1993 that all associated CEECs should be admitted to join the EU, provided they fulfil all the necessary conditions, including their ability to adhere to the aims of economic and monetary union. The so-called Copenhagen criteria serve as a strict benchmark by which progress on the way to economic and political compatibility with the EU is to be judged. The Copenhagen criteria are (i) the existence of stable institutions guaranteeing democracy, the rule of law, human rights, and respect for the protection of minorities; (ii) the existence of a functioning market economy and the capacity to cope with competitive pressures and market forces within the EU; and (iii) the ability to take on the obligations of membership, including adherence to the aims of political, economic, and monetary union (Temprano-Arroyo and Feldman 1998).

84. The Association Agreements have been criticized for potentially reducing intra-CEEC trade and investment.79 In addition, relatively strict rules of origins initially applied (e.g., on minimum local value added) for exports originating in the associated partner countries. The original cumulation provisions, determining the extent by which value added in other countries with a similar preferential trade agreement counts as local content, permitted only the bilateral cumulation (between individual CEECs and the EU) as well as the diagonal cumulation among selected countries (among the Visegrad countries and with the EU). Following an amendment of the relevant agreements in 1997, the EU extended the right for the diagonal cumulation of local value added to a significantly larger group of countries, including Estonia. “Originating products” can since be moved around more widely while still qualifying for preferential tariff treatment. This pan-European cumulation of origin removed potential obstacles for cost-efficient specialization in production and intra-industry trade within the EU periphery and notably improved Estonia’s trade and investment environment.80

85. The EU and Estonia signed an Association Agreement in June 1995 which entered into force in February 1998. The agreement fully replaced previous treaties with the EU (an Agreement on Trade and Commercial and Economic Cooperation, signed in May 1992, which was converted into a Free Trade Agreement in 1994) and expanded the scope of cooperation. In addition to the trade liberalization component, it includes provisions on the movement of labor and capital, the supply of services, economic, cultural and financial collaboration, the prevention of illegal activities, and a more intensive political dialogue. It also provides for financial support from the EU through PHARE, exceptional macrofinancial assistance, and loans and grants from the European Investment Bank.

86. Based on the Commission’s Agenda 2000, the EU has intensified its dialogue with the accession candidates through “Accession Partnerships.” Based on the favorable “Opinions” of the European Commission on membership, the European Council decided in December 1997 to start accession negotiations with Cyprus, the Czech Republic, Estonia, Hungary, Poland, and Slovenia that were formally launched in March 1998. In its first annual progress report on Estonia, issued in November 1998, the European Commission gave a broadly favorable assessment of Estonia’s progress, but also highlighted a number of shortcomings as regards administrative capacity. On the economic criteria, the report concluded that” .... Estonia can be regarded as a functioning market economy, and should be able to cope with competitive pressure and market forces within the Union in the medium term, provided that prudent macroeconomic management continues to limit the risks associated with its large external imbalances” (European Commission 1998). Estonia’s domestic agenda for meeting the requirement for EU membership is contained in its “National Programme for the Adoption of the Acquis” which is updated on a yearly basis.

87. In parallel with the accession negotiations, a thorough screening of national legislation aimed at identifying remaining discrepancies relative to the EU’s acquis is under way with the first group of accession candidates. Chapters which have already been closed (i.e. areas in which negotiations have been concluded) may at a later stage be reopened in light of the development of the acquis and the context of the final negotiation offers from both sides. It is likely that agreements on transition periods will need to be reached. However, given the challenges that eastward enlargement presents for the EU’s internal decision making procedures and financing structures, there will be limited scope for the applicants to influence the pace of the negotiations. It is currently expected that Estonia and the other CEE candidates will not become EU members before the year 2003.

C The Macroeconomic Impact of Further Economic Integration

Trade patterns in transition

88. Estonia is a small and very open economy. It has no external tariffs and only very limited restrictions on international capital mobility in the form of rules on FDI in some sectors (e.g., aviation, maritime sector, land sales). Free trade agreements are in force with all main trading partners except Russia.81 Underpinned by a currency board arrangement, the Estonian kroon is fully convertible and its exchange rate to the deutsche mark has remained unchanged at 8:1 since 1992.82 This transparent and liberal external policy framework has helped boosting Estonia’s trade with Western countries following independence in 1991 and has played an important role in attracting foreign investors.

89. Estonia has successfully integrated in the global trading system. Its external openness has grown over time, as evidenced by a ratio of goods and services exports and imports to GDP of 170 percent. This is, by far, the highest degree of openness among all transition countries (Table 9). Havrylyshyn and Al-Atrash (1998) have shown that Estonia and other CEECs have by now economies that are as open as market economies of similar size and per capita income. Since 1991, the direction of trade has shifted progressively and markedly toward the West and away from Russia and other CIS countries (Tables 10-12). Specifically, trade with Finland and Sweden across the Baltic Sea has risen strongly in recent years. The share of trade with Russia had already declined substantially through mid-1998, and triggered by the August 1998 events it fell sharply in the second half of 1998. By contrast, the share of exports to the EU countries rose from 48 percent in 1993 to around 62 percent in 1998.

Table 9.

Trade Indicators for Central and Eastern European Countries 1998

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Sources: IMF, Direction of Trade Statistics Database; Bank of Estonia.

Trade in goods and non-factor services as a share of GDP.

Trade in goods with the EU as a share of total trade in goods.

Table 10.

Reorientation of Central and Eastern European Countries’ Trade in Goods With the European Union, 1993-98 /1

(In percent of each country’s total exports/imports)

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Sources: IMF, Direction of Trade Statistics database; and Fund staff estimates.

Based on EU-15.

Table 11.

Estonia: Composition of Exports by Countries and Commodities, 1994-98

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Source: IMF, Direction of Trade Statistics database; Bank of Estonia.

From 1997 adjusted for transit trade.

Foodstuffs; textiles and textile articles; vehicles, aircrafts, vessels (consumption share 60 percent); furniture sportswear, other manufactured articles.

Table 12.

Estonia: Composition of Imports by Countries and Commodities, 1994-98

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Sources: IMF, Direction of Trade Statistics database; Bank of Estonia.

From 1997 adjusted for transit trade.

Foodstuffs; textiles and textile articles; vehicles, aircrafts, vessels (consumption share 60 percent); furniture sportswear; other manufactured articles.

90. Because of substantially lower labor costs than in Western Europe, Estonia has developed into a favorable location for Scandinavian and other Western high-technology firms seeking to outsource assembly work. Partly because of this, Estonia’s trade structure, and its export profile in particular, has converged markedly with that of current EU members as the share of manufactured exports, mainly electronics, in the commodity composition of trade has increased substantially. These “new exports” are characterized by a high value added and substantial potential for exports to the rest of the world. By contrast, the share of traditional, mostly agriculture-based exports to Russia and the CIS has declined (Table 11). As regards export-oriented manufacturing, Estonia has clearly benefited from its highly favorable geographical location at the crossroads between the East and the West but relatively close to Western European markets and its access to sea shipping. Because of the latter and as evidenced by large increases in services receipts, Estonia has flourished as a transit location for raw materials exported from Russia and other CIS countries to the West (in particular oil shipments). Finally, Estonia has benefited from a growing tourism industry which has been the second major source of services receipts in recent years.

The trade channel

91. The evolution of trade during the transition process as well as theoretical considerations presage that Estonia’s trade-orientation towards Western markets is likely to intensify further with closer integration. Theory suggests that international economic integration ultimately improves the allocation of resources (static effect) and leads to gains from increased competition on goods and factor markets (dynamic effect). This process involves a possibly disruptive shift of these resources to more productive uses and the adjustment of the economic structure to the more competitive environment. By strengthening its economic ties across borders, a country can take better advantage of a larger market with its partner countries, although it could also be more strongly affected by cyclical downturns in those countries. While the advantages from participating in a free trade area or customs union mainly accrue from a more efficient use of domestic resources through trade specialization, joining a common market also entails the elimination of obstacles to capital and labor mobility.

92. In order to assess the net effects of closer economic integration, both trade and financial linkages need to be considered.83 Trade-induced welfare effects are largely determined by the previous level of protection and the new common tariff regime to be adopted. As regards individual countries, it is ultimately an empirical question whether the benefits of trade creation will exceed the costs of trade diversion. In this context, it has been argued that the current system of bilateral EU association agreements may in fact exacerbate trade diversion and effectively reduce trade as well as investment activity among the associated CEECs (Baldwin 1994). Through the so called “hub-and-spoke effect” the EU membership candidates (“spokes”) may be marginalized to the benefit of the EU (“hub”). However, these considerations become less of a concern as the level of integration among the accession candidates is raised (e.g., through regional free trade initiatives such as the Baltic Free Trade Agreement).84

93. Rather than dismantling trade barriers at the border, Estonia will have to introduce certain restrictions on imports, particularly tariffs on agricultural products, which in principle could have an adverse impact on trade. It is indeed possible that EU accession may actually result in higher quantitative and non-quantitative trade barriers vis-a-vis non-members.85 However, all of Estonia’s main trading partners are also part of the EU’s extensive network of Free Trade Agreements and Partnership and Cooperation Agreements with ten CIS countries (including Russia and the Ukraine). With the general level of trade protection thus being low, the potential for trade diversion appears to be limited. Exports from only a few countries are expected to be affected by the introduction of tariffs.86 The already large share of EU imports in overall imports also points to minor welfare losses from adopting external tariffs.

94. By contrast, trade links with the EU are bound to deepen further, given the close economic ties and the alignment of the legal and regulatory frameworks with EU norms. Also, trade with the EU can be expected to increase further to the extent that more FDI will flow into export production. Studies based on gravity models have shown that, in general, there is a potential for further expansion of CEEC exports to the EU, with an expected share of CEEC exports to the EU of 70 percent or more.87 Given that Estonia’s share of exports to the current 15 EU members reached 62 percent in 1998, there appears to be room for further expansion (Tables 10-12).

95. The trade impact of EU accession will to some extent also depend on further improvements in the degree of market access to the EU, especially as regards agriculture and services which are not or only partially subject to the provisions of the association agreement. In these sectors, market access will depend on Estonia’s progress in adopting and implementing relevant EU regulations. This, in turn, will require building up the necessary administrative capacity. Equally important is the ability of the private sector to comply with the sanitary and safety standards required for the sale of products within the common market. Upon accession, the impact will be smaller if Estonia prepares itself well with regard to meeting the requirements of the single market during the pre-accession period.

96. As regards the EU’s CAP, Estonia has started preparing the institutional and policy framework needed for its introduction. This will subsequently lead to protection from non-EU farmers and the agricultural industry more generally. At the same time, Estonia’s agricultural producers will not be discriminated against in other EU countries. Both changes foster exports of agricultural exports to the EU and other CEECs. As regards services, better opportunities due to gaining market access to the EU, especially in the transport sector, will partly compensate the negative impact from less favorable trade relations with Russia. There is also a good chance for travel services receipts to increase further as visa-free travel to and from some EU countries has already become possible.

97. EU accession is likely to further enhance domestic competition and spur structural change. The intensity of competition from abroad is relevant for judging the potential dynamic gains from trade in goods and services. Although Estonia’s liberal trade regime already facilitates market entry by foreign firms, there appears to be further scope for additional dynamic integration gains from increased competition due to EU accession. It is this dynamic impact of joining the EU’s common market in the form of spurring competitive pressures and fostering restructuring as well as innovation that is likely to be the predominant integration effect in the medium term. It promises to lead to a sustained increase in output capacity as well as a rise in total factor productivity.88

The financial channel

98. Estonia has experienced major foreign capital inflows which were sufficient to cover its large savings-investment imbalance. The current account deficit amounted to over 13 percent of GDP in 1997 and 8.6 percent of GDP in 1998. The composition of capital inflows has recently improved markedly in favor of non-debt creating flows and longer maturities.89 Foreign direct investment (FDI) increased sharply in 1998 as the two largest commercial banks benefited from large capital injections from Scandinavian investors. In early 1999, the (partial) privatization of the major telecommunications parastatal (Eesti Telekom) provided a further large inflow of capital. Whereas during 1989-98, the Czech Republic, Hungary, and Poland received most FDI in absolute terms, Estonia was the second largest recipients of FDI on a per capita basis. Most of Estonia’s FDI inflows originated from the EU (Tables 13-14).

Table 13.

Foreign Direct Investment (FDI) Indicators for Central and Eastern European Countries, 1989-98

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Sources: IMF, International Financial Statistics, and World Economic Outlook.
Table 14.

Estonia: Shares of Net Foreign Direct Investment Inflows by Country of Origin and Field of Activity, 1994-98

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Source: Bank of Estonia.

99. In the past few years, these inflows have not only helped finance large current account deficits and increase foreign exchange reserves, but they have also provided a major stimulus to economic growth through the provision of new equipment, up-to-date technology, and modern management practices. It appears likely that Estonia will continue to be able to attract foreign investors, including from non-EU countries, given its improved access to an enlarged EU market and its proximity to Russia and other CIS countries. Macroeconomic stability, progress in structural reforms to increase productivity, and maintaining a qualified labor force will, however, also be essential to continue attracting foreign capital.

100. Its liberal policy regime has allowed Estonia to take full advantage of its comparative advantages in trade, including transit services, which also enhances the favorable climate for foreign investors. These advantages will be further strengthened by the full adoption of the EU financial sector directives which provide a stable and predictable legal framework for investment. The adoption of the comprehensive package of EU legislation will make it easier for multinational enterprises to include Estonia into their Europe-wide business strategies. Furthermore, EU membership is likely to ensure that inflows of capital, technology and know-how continue after the major privatization projects (e.g., energy production and distribution, railways) are completed.

101. As with trade, the additional impact of accepting those elements of the EU’s common market relating to capital transactions, particularly the provision of cross-border financial services, cannot be easily isolated. The additional welfare impact from capital mobility will not depend solely on the adjustment of the regulatory environment but also on the macroeconomic policies and the level of development and soundness of the domestic financial system. Due to its open capital account and full currency convertibility, Estonia already has relatively easy access to international capital markets.90 This has increased competitive pressure in the domestic financial sector and raised the efficiency of financial intermediation.91

102. These processes can be expected to intensify through further integration into EU financial markets. By strengthening these links, accession will likely spur domestic financial sector deepening. Additional welfare effects will arise from stronger competition in the domestic financial sector fostered by free market access for providers of financial services. Adherence to EU regulations on capital movements and financial services and minimum standards for bank regulation and supervision can also be expected to contribute to improved financial sector intermediation.92 This environment is bound to spur securities trading, increase portfolio flows, and render the stock market more liquid. Foreign bank borrowing and equity financing abroad should become easier not just for larger but also for medium-sized Estonian enterprises, while firms should also be able to benefit from intensified cooperation among the Baltic stock exchanges, which is already underway. Fiercer competition on both domestic and EU-wide financial markets should not only strengthen financial systems, but also result in better access to financing and lower interest rates.

103. A direct effect from EU accession on economic activity in Estonia will result from the amount of transfer payments to and from the EU, with grant and loan financing as inflows and EU contributions as outflows. According to the EU budget provisions of Agenda 2000 which were adopted by the European Council in March 1999, there will be pre-accession financing available for all membership candidates, namely for infrastructure and environmental projects, for agriculture, and for technical assistance and training (through PHARE). Financial support from these instruments will be available from 2000 to 2006 or until a country becomes a EU member.93 The EU has also agreed to an indicative medium-term financial framework for an enlarged EU comprising 21 countries which, from 2002, sets aside substantial financial support exclusively for new members (Table 15). It remains to be seen how these funds will be allocated within this group and what the financing obligations of these countries with regard to the EU budget will be. According to staff estimates, net transfer receipts for Estonia could reach about 2 percent of GDP per year over the medium-term (implying a net transfer of approximately US$160 million for 2003, the first possible year of membership). In subsequent years, this sum would rise by about US$10 million per year in line GDP growth.

Table 15.

EU Financial Support for Accession Candidates 2000-06

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Source: European Council Berlin.

104. Approaching EU membership is also likely to influence creditors’ perception of sovereign and currency risk, thereby reducing the risk premium on domestic interest rates. Financing would become cheaper and interest rate arbitrage using debt instruments denominated in deutsche mark would subsequently become less profitable.

D. Fiscal Policy Challenges and the Budgetary Impact

105. EU accession will bring about a number of important fiscal policy changes and is likely to have a significant impact on budgetary performance. Fiscal policy challenges will comprise the need for further harmonizing tax policies, streamlining budget formulation and management, and rationalizing public administration. The net budgetary impact of EU accession is, however, difficult to project since future fiscal and other domestic policies as well as EU related fiscal measures are uncertain. Also, the size of grant and loan financing that may become available due to EU accession remains uncertain.94

106. Estonia’s fiscal policies in the past have generally been prudent, which has been key for supporting its currency board arrangement since 1992. Fiscal deficits have remained limited, and in 1997 and the first half of 1998 sizable fiscal surpluses were achieved. These fiscal surpluses, together with large privatization proceeds, were saved abroad in the Stabilization Reserve Fund (SRF).95 External public debt stood at 5 percent of GDP in 1998, but was even lower, at 3.3 percent of GDP, if SRF holdings are included. By this measure, the level of debt declined to below 2 percent of GDP in March 1999 due to the addition of considerable privatization revenues to the SRF. Although the EU does not require the accession candidates to focus on the Maastricht criteria (see below), Estonia comfortably satisfied the fiscal deficit and public debt criteria (Table 16).

Table 16.

Prospective European Union Members: Convergence Indicators, 1998

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Sources: IMF, World Economic Outlook, and International Financial Statistics.

The fiscal policy framework

107. EU accession will require further, albeit limited, tax harmonization for Estonia. Its present tax system is relatively transparent, simple, and efficient especially as regards the taxation of enterprise profits and personal incomes (flat tax of 26 percent).96 This puts Estonia in a relatively favorable position vis-à-vis current and other prospective EU members. It is thus hardly vulnerable to possible tax revenue losses due to outmigration of enterprises or workers. On the contrary, Estonia’s simple tax structure is one possible explanation for its continued attractiveness among foreign investors.

108. As regards the direct tax system, only relatively minor adjustments would appear necessary to comply with EU requirements.97 Changes required in the area of indirect taxation may be of greater significance, including, in particular, the introduction of customs tariffs. Currently, Estonia has no external tariffs, whereas the average ad valorem external tariff of the EU is 5.5 percent.98 While customs tariffs will be collected by Estonia on accession, they will be fully paid to the EU budget (apart from a deduction made for collection costs) and will thus generate no additional revenue. As regards VAT, the EU requires that the standard rate should not be lower than 15 percent, implying that Estonia could reduce its standard rate by up to 3 percentage points. Estonia is also in compliance with the requirement that the preferential rate should not be lower than 5 percent. However, there will be a need for Estonia to abolish a few VAT exemptions and to eliminate the zero rate currently applied to heating costs. Necessary adjustments in excise tax rates have already been undertaken and more increases are likely to follow over the next few years on the basis of an already prepared medium-term plan.

109. During the pre-accession phase and beyond, budget revenues could rise from buoyant tax collection in line with prospects for stronger real GDP growth, higher excise tax rates, and the newly introduced property tax. These receipts could be offset by a lowering of selected tax rates, including the standard 18 percent VAT rate, considering that the tax burden in Estonia’s economy is already fairly high.

110. EU accession is likely to cause significant additional expenditure pressure, mostly because of the need for increased public sector investment on infrastructure and the environment.99 The recurrent expenditure burden on the budget is likely to increase only moderately, reflecting the need to comply with EU standards and the creation of the necessary legal and institutional preconditions for EU membership.100 However, as the Estonian public sector is already relatively large, efficiency gains in other parts of the public administration and the re-deployment of staff may offer scope for dampening spending increases. According to staff estimates, the general government wage bill and other current expenditures would need to rise by less than 2 percent due to EU membership.101

Investments and transfers

111. Public sector investment outlays are likely to rise in the run-up to accession, reflecting first of all the need to comply with EU requirements. Investments will also increase due to improved access to grants and concessional loans. Capital spending remained slightly above 4 percent of GDP in 1998, but the share of projects officially classified as “public investments for Eurointegration” rose to almost 40 percent under the 1999 budget (equivalent to EEK 1.5 billion or 1.8 percent of GDP). Also, the sectoral allocation of investment projects has already begun to shift in favor of sectors such as environmental protection and infrastructure. It is expected that the share of public investment in GDP will rise over the medium term, which calls for significant improvements in public expenditure management and project prioritization.

112. There are, as yet, no reliable estimates regarding the total costs of required investments. However, the World Bank has estimated that investments in the energy sector alone could amount to at least US$200 million during the period 1996-2005 (World Bank 1999). The overall figure including all sectors will likely be significantly higher since there is a need for sizable investments also in other areas (e.g., environment, infrastructure).

113. Sizable funding from the EU will become available to meet the considerable investment needs. As indicated above, the EU’s new medium-term budgetary framework includes significant pre-accession expenditure for the countries which are actively seeking membership. As a vehicle for financial support targeted at infrastructure and environmental projects, the “Instrument of Structural Policies for Pre-Accession” (ISPA) will provide a yearly amount of EUR 1.04 billion for seven years starting in 2000. To access a share of these funds, Estonia will have to meet additionality requirements, which calls for co-financing and therefore real increases in domestic spending on proposed projects or programs.102 During the same period, PHARE funding up to EUR 1.56 billion per year for institution building, training, and investment in other areas will be made jointly available for the accession candidates. Estonia will continue to benefit from these transfers until becoming a member.

114. Estonia can also expect to receive transfers directed at the agricultural sector. During the pre-accession period, the EU is committed to make available agricultural aid of EUR 520 million per year (for seven years starting in the year 2000) to the accession candidates to facilitate CAP implementation. The magnitude of these projected transfers may yet change should further reforms of the CAP take hold. For Estonia, the size of pre-accession agricultural funding and subsequent CAP transfers is likely to be limited considering the small, and declining, share of agriculture in GDP (about 5 percent of GDP). The importance of external farm support is further reduced by the fact that it will substitute rather than complement Estonia’s present, modest, budgetary support for the agricultural sector.103

115. The considerable scale of financing under the pre-accession instruments will continue upon accession. As a new EU member, Estonia will be a net recipient of EU transfers given its low per capita GDP.104 It will qualify for grant and loan funding from the European Structural Funds (ESF) and the Cohesion Fund (CF).105 The EU’s Agenda 2000 as endorsed at the meeting of the European Council in March 1999 sets out an upper limit of 4 percent of GDP for total annual receipts by any member state from these structural operations (European Council Berlin 1999). However, actual external financing would be somewhat lower than this ceiling if Estonia’s absorption and implementation capacity prevented it from tapping EU funds fully. Furthermore, transfers receipts will be partly offset by Estonia’s contribution to the financing of the EU. Currently, member states’ annual contribution is equivalent to about 1 percent of national GNP. On a prudent estimate, therefore, net transfer receipts from the EU in the magnitude of about 2 percent of GDP per year over the medium-term appear plausible.106 Most of these inflows are likely to be channeled to the public sector.

E. EMU Participation

116. The EU has made accession conditional on subscribing to the objectives of EMU. Prospective new EU members cannot avail themselves of an “opting-out” clause that has been granted to the United Kingdom and Denmark. While this implies a requirement for membership candidates to prepare themselves for eventually adopting the euro, it does not require that would-be EU members fulfil the macroeconomic convergence criteria for participation in the euro area at the time of EU accession. During the pre-accession period, the EU requests that membership candidates primarily focus on meeting the Copenhagen economic criteria (see Section B above) and implementing structural reforms with the objective to complete the transition to a market economy. The Maastricht convergence criteria are only points of reference and will become relevant only upon accession. Estonia’s good track record of prudent macroeconomic policies nevertheless already provides a good basis for meeting the Maastricht criteria. Budget deficits have been limited, or nonexistent, and the level of public debt has remained low (Table 16). While substantial progress has been made in reducing inflation in 1998 and early 1999, interest rates have remained persistently above those in Germany and other EU members despite the peg of the kroon to the deutsche mark.

117. More immediate institutional implications for CEE candidates arise from the need to meet all legal and institutional requirements that apply to EU countries not participating in the euro area. As so-called “member states with a derogation” they will have to comply with a range of conditions aimed at establishing the preconditions for participation in EMU.107 These include the complete liberalization of capital flows both vis-à-vis EU and third countries, the establishment of an independent central bank which pursues price stability as a primary goal and is prohibited from direct or indirect financing of the government as well as the participation in the European System of Central Banks. Also, governments are obliged to treat economic policy, in particular exchange rate policy, as a matter of common interest and engage in the EU’s policy coordination and surveillance procedures.108 Among the CEE accession candidates, Estonia is well advanced in meeting these legal and institutional accession requirements. The central bank’s role and functions were suitably defined in the context of setting up the currency board in 1992. It is statutorily independent with price stability as its primary objective and prohibited from purchasing government securities in the primary market. Also, capital movements were liberalized early on in transition, which should facilitate linking the domestic payments system with the network of cross-border settlements systems of the euro area.

118. EU accession will also entail entering into a formal exchange rate arrangement with the EU, an area which is not covered in detail in the association agreements. Currencies of EU members that have not adopted the euro can be linked to the euro through the Exchange Rate Mechanism II (ERM II).109 In the case of Estonia, its long-standing strong formal link of the kroon to the deutsche mark suggests that such an exchange rate arrangement could consist of a formal peg to the euro in the context of a currency board.

119. The Estonian kroon is pegged to the deutsche mark, and thus since January 1, 1999 also to the euro. While introducing the euro as the national currency would amount to a change in the monetary policy regime, it would nevertheless imply continuity. Under EMU, the Bank of Estonia would be part of the European System of Central Banks with limited influence on euro-area monetary policy making. However, Estonia would maintain its responsibility for regulating and supervising the domestic financial sector.110

120. In terms of economic impact, the replacement of the currencies of most EU members with the euro represents a deepening of the EU’s common market. Monetary union reduces the costs from doing business within the euro area by removing currency fluctuations and making the hedging of currency risks unnecessary. Furthermore, the improvement in price-transparency across borders is bound to spur competition in the goods and services sectors over the medium term, leading firms to reassess their current business strategies based on separate national markets. Estonian firms will be exposed to these mounting competitive pressures but will also be able to take advantage of the opportunities gained in being part of the euro area. These include, in particular, cost reductions in trade within the large “home” market as well as in financing business activities. The latter should follow the emergence of a large and liquid pan-European financial market which would improve direct access for large and medium-sized firms to capital markets abroad and reduce the costs of financing business activities.

121. The position of Sweden with regard to its future participation in the euro area is of particular interest for Estonia. Should Sweden choose to remain outside the euro area even after Estonia has joined, bilateral trade would continue to be saddled with transaction costs related to currency fluctuations, even if limited in practice. In this case, the possibility of some diversion of trade away from its currently second largest trade partner into the euro area cannot be entirely dismissed.

122. Additional growth impulses from joining the euro area are likely to arise from the fact that short-term interest rates will eventually equal those in the rest of the euro area. Given the size of Estonia, interest rate convergence in the run-up to adopting the euro will happen unilaterally, bringing the rate of domestic interest rates down to the lower level of the euro area. This could fuel domestic economic activity, depending on the extent by which banks’ domestic credit activity responds to reduced financing costs.

123. Full convergence is neither required nor likely for long-term interest rates. However, the policy credibility gained via participation in the euro area will further improve Estonia’s sovereign ratings and its standing on the financial markets. The perceived reduction in sovereign risk and the elimination of currency risk will be reflected in a reduction of today’s risk premium relative to other euro area debtors. Long-term financing for Estonian borrowers could thus also become considerably cheaper, spurring investment activity by Estonian firms and supporting growth.111

F. Conclusions

124. Membership in the EU and adoption of the euro will have important implications for Estonia’s macroeconomic policies and performance. Estonia is likely to benefit via the trade, financial, and fiscal channels from further formal integration with Europe. Greater market access and increased trade as well as reduced costs and more competition will support real growth. The expected reduction in the risk premium and further integration into Western European financial markets are likely to improve access to financing on more favorable terms. And on the fiscal side, Estonia is likely to benefit from significant transfer payments.

125. However, there will also be costs related to EU accession in the form of additional expenditure pressures, largely on account of required investments in the environment and infrastructure sectors. In the absence of other adjustments, this will result in a notable increase in the share of public expenditure to GDP. To the extent that an expansionary effect on domestic demand ensues, spurring imports of consumer products and project related investment goods, the current account position could be significantly affected.112 Lower interest rates which tend to boost domestic investment could compound an eventual widening of the external imbalance. At the same time, however, inflows of foreign capital will help to expand and modernize Estonia’s production and export capacity and result in a quick and strong supply-side response of the economy. Most importantly, the net effect of EU membership on the balance of payments will also depend on private saving behavior and fiscal policies.

126. Estonia would be well advised to prepare for EU membership by (i) continuing to pursue a prudent fiscal policy stance; (ii) liberalizing the remaining administered prices; (iii) maintaining a flexible labor market; (iv) taking measures to foster competition on domestic goods markets; (v) finalizing pension reform consistent with promoting private saving; and (vi) further improving financial sector supervision.

127. If Estonia maintains and strengthens its policy stance along the lines suggested above, it should be able to cope with the challenges of EU accession and participation in EMU. During the pre-accession period, and beyond, Estonia holds considerable sway over its fiscal and structural policies to smooth the accession process and dampen the impact of possible shocks related to further integration into the EU and the global economy.


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Websites la/enlarge/agenda2000_en/agenda.htm (European Commission Agenda 2000) la/enlarge/index.htm (European Commission DG1A, Enlarging the European Union) (Enlargement Links, EU Task Force for the Accession Negotiations) la/enlarge/access_partnership/estonia/estonia_ap.htm (EU Accession Partnership with Estonia) (Draft Regulations on the EU’s Structural Funds, the Cohesion Fund, and the Instrument for Structural Policies for Pre-Accession, ISPA, for 2000-06) la/phare/index.htm (EU PHARE Programme) (Central Bank of Estonia) (Ministry of Finance of Estonia) (EU enlargement, Vienna Institute for International Economic Studies)


Prepared by Gunther Taube and Rene Weber. Helpful comments on an earlier draft were received by Mr. Bernard Brunet from the European Commission.


The following Central and Eastern European Countries (CEECs) are also membership candidates: Bulgaria, Latvia, Lithuania, Romania, and Slovakia.


For a summary of structural reforms in Estonia since independence see Chapter II, for a detailed discussion of reforms in the financial sector see Chapter III.


As Havrylyshyn (1998) points out, it is also important to acknowledge that EU enlargement and EMU are not the only mechanisms of further economic integration in Europe. These include, for example, the various forms of cooperation among the states surrounding the Baltic Sea.


Without the option of EU accession, Estonia may have joined not only EFT A but also the European Economic Area, where much of the regulatory requirements are modeled on those of the EU.


These “Europe Agreements” define the lines of cooperation in a wide range of policy areas, triggering far-reaching adjustments in the legal and regulatory frameworks, particularly in trade-related areas such as competition, state subsidies, customs, product standards, and intellectual property rights. For more details on the general nature and contents of these agreements see Temprano-Arroyo and Feidman (1998) or Pautola (1996).


To provide guidance regarding the most important items of the EU internal market legislation, the European Commission issued a “White Paper” in May 1995. Support in strengthening administrative capacities to implement the acquis is given through the process of “twinning” under the PHARE program, which makes technical and administrative expertise of EU member countries available to accession candidates.


On these so called “hub and spoke” effects, which are related to relatively high intra-CEEC tariffs or legal uncertainty, see further below.


After Turkey was included at the beginning of 1999, these cumulation provisions now apply to 32 countries, namely the members of the EU, EEA and EFTA, the 10 associated CEECs, as well as Andorra, San Marino, and Turkey. See Temprano-Arroyo and Feidman (1998).


Estonia has signed bilateral Free Trade Agreements with Hungary, Poland, the Czech Republic, Ukraine, the Slovak Republic, Slovenia and Turkey. It is a member of EFTA and has ratified the Baltic Free Trade Agreement with Latvia and Lithuania. WTO membership status is expected for 1999. For a detailed analysis of Regional Trade Arrangements with Estonian Participation see Sorsa (1997).


Estonia’s currency board arrangement has been analyzed by Bennett (1992, 1994), Pautola and Backé (1998), Sepp (1995), and Baliño et al. (1997).


For a more detailed theoretical discussion of these linkages and relevant empirical evidence see Russo (1998) and Feldman et al. (1998).


In addition, the extent of possible discrimination depends on the existing regime for rules of origin and the regulations on market access for services.


For example, it has been shown that trade barriers versus non-EU members increased following the creation of the European single market in January 1993. See Taube (1992).


The main countries affected are Australia, Canada, Japan, New Zealand, Taiwan, and the United States to which the EU accords only most-favored-nation (MFN) treatment. The impact is limited for Russia and the Ukraine which have preferential access to the EU market on the basis of their Partnership and Cooperation Agreements.


For a summary of these studies see Feidman et al. (1998).


See for example the analysis of welfare effects of the European Communities’ Common Market Program by Emerson et al (1988).


For detailed discussions of debt levels and profiles in the BRO countries see Odling-Smee and Zavoico (1998) and Kapur and van der Mensbrugghe (1997).


The major rating agencies have recently confirmed Estonia’s investment grade rating on foreign currency denominated long-term debt (Moody’s: Baal, Standard and Poor’s: BBB+, FitchlBCA: BBB; situation end April 1999).


For details see Chapter III.


The EU financial sector directives include a large body of regulations on banking, capital markets and insurance. For a description of the EU framework in this area and the degree of compliance by Estonia see Cavalcanti and Oks (1998).


From the date of membership, the regular EU support mechanisms will apply while funding through PHARE will cease.


Additional grant and loan financing may also become available bilaterally from current EU members.


As of end-March 1999, fiscal reserves in the SRF amounted to EEK 2.8 billion, equivalent to 3.5 percent of projected 1999 GDP. See Chapter IV.


See Kopits (1992), Tanzi and Zee (1998) for discussions of tax harmonization and competition issues in the context of EU integration.


It is likely that the EU will require the abolition of recently introduced profit tax deductibility of fixed costs for all enterprises outside Tallinn over and above the customary deduction of depreciation. This measure was approved by parliament in January 1999 and became effective retroactively from January 1, 1998. It is also questionable if the EU would accept the maintenance of “free-zone status” for a number of ports and towns. See Cangiano and Mottu (1998) who discuss EU and OECD efforts to tackle harmful preferential tax regimes. On other taxes, the Estonian authorities have already initiated work on preparing a medium-term plan for gradually replacing the land tax with a property tax, which is also required by the EU. For details on Estonia’s current tax system see IMF (1998) and Berg (1997).


For agricultural goods, the average trade-weighted external tariff of the EU is 16.4 percent.


Budgetary spending will also be affected significantly by decisions in other, non-EU related domestic policy areas, including pension reform.


For example, the EU has identified the need to increase staffing in the Customs Board, the National Tax Board, the State Audit Office, and institutions responsible for enforcing veterinary and sanitary conditions and controls as well as health and safety standards at work.


Assuming an increase in the number of general government employees by not more than 2,000 persons over and above the current level of slightly less than 140,000 employees.


EU financial assistance for ISPA projects is normally 75 percent of the total outlays of a project, although the European Commission can propose to increase it to 85 percent under exceptional circumstances. The costs of technical support and feasibility studies can be financed exceptionally at 100 percent, but the costs for such operations cannot exceed 2 percent of the national ISPA budget.


Introducing the CAP will of course have a direct favorable impact on producers and an immediate negative impact on real incomes of consumers. Leaving redistributive effects aside, the net effect on aggregate GDP should be minimal or zero according to World Bank estimates.


Under current rules, EU Structural Funds are available to member countries if their GDP per capita is lower than 75 percent of the EU average measured at purchasing power parity levels. With a nominal per capita income of roughly 30 percent of the EU average, Estonia falls well below this threshold (Oxford Analytica 1998).


Structural Funds include the Social Fund (ESF), the Regional Fund (ERDF), part of the support for agriculture (EAGGF), and aid for fishing communities (FIFG). For the period 1994-99, total assistance provided to members through the Structural Funds was ECU138 billion (Begg 1998).


This rough estimate does not account for CAP-related transfers. Note that an increase in capital spending will have potentially sizable recurrent cost implications.


The “derogations” are temporary, except for the United Kingdom and Denmark. The inclusion of actual transitory periods in the EU accession treaties concerning these institutional criteria appears unlikely since the membership applicants have expressed their preference to join as soon as possible. Even if these accession candidates make rapid progress on institutional reform and macroeconomic convergence, however, concerns on the side of the EU about real and structural convergence remain. See Feidman et al. (1998).


The most important of coordination and surveillance procedures are the broad economic policy guidelines, the convergence programs and the excessive deficit procedure. For a detailed list of the respective rights and obligations see Temprano-Arroyo and Feidman (1998), Table 6.


ERMII is designed as a flexible system with wide standard fluctuation bands (±15 percent), timely realignments, and the possibility of progressively tighter exchange rate links. Participation will be voluntary. The system is asymmetric to the extent that any intervention in the foreign exchange markets by the ECB must not interfere with the ECB’s primary objective of price stability. The costs of intervention and realignment are thus largely borne by the country outside the euro area. It is not yet clear to what extent ERM II will be open to accession candidates wishing to build up a track record of exchange rate stability against the euro before EU membership in order to facilitate EMU participation later on. For a discussion of the implications of EMU for exchange rate policies in Central and Eastern Europe see Kopits (1999).


Under EMU, banking sector supervision remains a prerogative of national supervisory authorities. With a view to the cross-border activities of banks, regular meetings of these authorities with the ECB are held. The central bank will also need to assure to make the domestic payments system compatible with the Europe-wide real time gross settlement system (TARGET) through which the ECB conducts monetary policy.


While the introduction of the euro has removed currency risks as a source of interest rate differentials within the euro area, the remaining interest rate spreads mirror differences in country risks, in part linked to diverging fiscal policies and performance.


According to the IMF’s Balance of Payments Manual (Fifth Edition, 1993), investment grants should be classified as capital transfers. While the bulk of EU-related inflows is likely to involve such investment grants, some current transfers (e.g., technical assistance, CAP support) will also take place.