Abstract
This paper assesses Estonia’s flexibility from two angles. The paper focuses on one aspect of that performance—the ability to sustain competitiveness. Then, a more forward-looking angle is the flexibility of Estonia’s labor and product markets. Estonia has made great progress in achieving real convergence in the last decade. Current account deficits are integral to convergence. A key question raised by this analysis is whether the large external imbalances and the counterpart buildup in external obligations will be smoothly reversed.
I. Competitiveness and Sustainability in Estonia1
A. Overview
1. Estonia’s currency board arrangement (CBA) and its commitment to adopting the Euro both require an ability to adjust to changing conditions without using the exchange rate. This paper assesses Estonia’s flexibility from two angles. The first is its performance under the CBA during the last decade and a half. Since the CBA imposes exactly the same discipline on policy as will membership of a currency union, performance during this period is a predictor of performance under the euro. The paper focuses on one aspect of that performance—the ability to sustain competitiveness. The second, more forward-looking, angle is the flexibility of Estonia’s labor and product markets. Flexibility is necessary because the next phase of convergence will bring challenges that are different from those that were successfully met during the first phase. In particular, a significant current account adjustment will be needed in order to stabilize the ratio of external liabilities to GDP—which has risen rapidly during the decade. And this adjustment may need to come against the backdrop of slower growth resulting from the maturing of convergence, the elimination of cyclical unemployment, and the anticipated decline of the population.
2. Estonia has made great progress in achieving real convergence in the last decade. As a result, its living standard has risen from among the lowest in the EU’s new member states (NMS) to solidly in the middle (Figure 1). This has been achieved through high investment rates, averaging 33 percent of GDP in the last five years, some 8 percentage points above the NMS average (Figure 2). With a saving rate of only 23 percent of GDP (still 3¾ percentage points above the NMS average), Estonia’s average current account deficit has been the largest in the region, about 10 percent of GDP. This has contributed to a large negative net international investment position (NIIP), equivalent to almost 100 percent of GDP at end-2005.
EU8 Member States: Progress in Income Convergence to EU25 Average, 1996–2005
(GDP per capita in Purchasing Power Standards (PPS))
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Sources: Eurostat; and staff calculations.1/ Percentage point change in the ratio of per capita GDP to the average in the EU25.Estonia: Investment, Saving and Current Account Shares, 1993–2005
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Sources: WEO; and staff calculation3. Current account deficits are integral to convergence. They reflect both high rates of investment in response to relatively scarce capital and well-educated labor forces, and consumption smoothing by households in anticipation of higher future incomes. Both are facilitated by new or expanded access to credit. Stavrev (2003) found that these forces are capable of explaining most of the current account magnitudes seen in the Baltics in the last decade. Bems and Hartelius (2006) construct two-sector neoclassical growth models with dynamically optimizing households and enterprises, calibrated to data for the Baltic economies, and are also able to account for the observed magnitudes of the trade deficits experienced for 1995–2004. Moreover, as discussed further below, their model also generates an initial relative decline in the traded goods sector, as the nontraded sector blossoms, followed by a re-emerging traded sector necessary to service external debt. An IMF (2006) study of growth in EU NMS also notes the beneficial role of foreign saving in accelerating real income convergence.
4. A key question raised by this analysis is whether the large external imbalances, and the counterpart buildup in external obligations, will be smoothly reversed. This depends in part on the current and prospective competitiveness of the tradable sector, and the flexibility of the economy—the two issues addressed next.
B. External Competitiveness Indicators
5. The standard approach to examining external competitiveness relies on measures of real effective exchange rates (REERs). Most of these are constructed by deflating nominal effective exchange rates by some relative price or cost measure. Each has merits and limitations, often trading off precision against data availability and timeliness. Lipschitz and McDonald (1992) present and analyze various measures, and recommend monitoring a range of indices as well as sectoral developments, thereby allowing for a richer and more firmly based set of inferences.
6. Estonia’s real effective exchange rate has appreciated at a pace broadly comparable to those in other NMS, but this appreciation need not imply a loss of competitiveness. Figure 3 examines various REERs, including ones based on deflators for overall GDP (REERgdp), and for value added in industry (REERind), as well as for unit labor costs in manufacturing (REERulcm).2 All three measures show a slow but steady rise in Estonia of some 3½–6½ percent per year since 1995. The increases are broadly similar to those in other NMS: higher than in Poland, Hungary, Latvia and Slovenia, but lower than or the same as in the Czech Republic, Lithuania, and Slovakia. These increases, which appear to imply a loss of competitiveness, are also consistent with other possibilities. In particular, the rise in the GDP-based measure may reflect Balassa-Samuelson effects, as comparatively high productivity growth in the traded sector induces relatively higher price increases in nontraded sectors in the NMS compared with their trading partners. This is a natural concomitant to real convergence and would not suggest a worsening in external competitiveness. It is notable that the largest increases in this measure occurred in the rapidly converging Baltic states.
Estonia: Real Effective Exchange Rates, 1995–2006 /1
(2000 = 100)
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Sources: European Commission; and staff calculations.1/ REERgdp is the real effective exchange rate against the EU12 based on relative GDP deflators, while REERulcm is based on unit labor costs in manufacturing, REERind is based on industry deflators, and REERlab is the ratio of REERulcm to REERind, and is identical to changes in an economy’s labor income share in manufacturing relative to that in the EU12.External Competitiveness Indicators: Manufacturing
(2000 = 100)
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
7. REER measures placing more weight on traded goods have also appreciated, although generally by less than the GDP deflator-based measure. This is to be expected because the Balassa-Samuelson influences on these measures would be smaller. While the appreciation of these measures could signal losses in competitiveness, they may instead reflect compositional changes in the NMS’s industrial sectors relative to those in their trading partners, and/or relative improvements in product quality, giving rise to higher export prices. As Estonia climbs the technological ladder in its exports, shifting from agricultural and textile products to higher technologically embodied products (including telecommunications equipment), its industrial deflator may have increased relative to its trading partners due to compositional changes. The shift in product mix is discussed in (Box 1).
8. The fourth, and most revealing, external competitiveness measure, which compares manufacturing labor’s income share in the home country relative to those in its trading partners, suggests that Estonia’s external competitive environment is becoming more demanding. REERlab, which is calculated as the ratio of REERulcm to REERind, should not be systematically influenced by trend changes in export composition.3 An increase in the index indicates falling profitability in an economy’s traded goods sector relative to trading partners. This index has shown little variation over time in Estonia, and in fact declined slightly over the last decade. However, it has increased somewhat in the last two years, and calls for close monitoring. Since labor’s economy-wide income share in Estonia has been stable during this period, the increase likely reflects an improvement in trading partner profitability (e.g., from Nordic and German wage moderation, Figure 4). This suggests that the external competitive environment is becoming more demanding.
Estonia: Employee Compensation Share of GDP, 1993–2006
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Sources: Statistical Office of Estonia; and staff calculations.Estonia’s Improving Export Composition
Estonia’s economic restructuring has been evident in its export composition. The demise of the previous distorted trading system, both within the former Soviet Union as well within the CMEA, has resulted in a significant shift of productive factors toward areas with higher economic returns.
The change in export composition comprises both shifts in product mix and improvements in quality, a process underway to a relatively larger degree in Estonia than in most other new member states. The improvement in export composition and quality among EU new member states, taking advantage of comparatively well-educated workforces given prevailing wages, is well documented (see Zaghini (2005), Landesmann and Wörz (2006) and Fabrizio, Igan and Mody (2006)). In Estonia the shift was pronounced. The relative importance of animal and vegetable products and foodstuffs, which accounted for almost one-quarter of exports in the early 1990s, has declined substantially, as has to a lesser degree that of textiles. These products have been supplanted by machinery and equipment exports, especially for telecommunication goods. The share of “high-tech” exports increased rapidly in late 1990s, although it has subsequently slipped somewhat (Figure 5). Nevertheless, it compares well to developments in other new member states (Figure 6). Moreover, the improvement in the quality of exports implied by increases in the ratio of Estonia’s export unit values to those of other exporters of similar products, has been among the highest in the region.
Estonia: Composition of Exports, 1993–2005
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Sources: Statistical Office of Estonia; and staff calculations.Estonia: Export Composition in the EU-15 Market, 1994–2004
(Share in percent of country exports-LHS; UVR-RHS)
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Source: Fabrizio, Igan, and Mody (2006).Note: Low technology industries include food products, beverages and tobacco, textiles, leather, wood and paper products, and basic metals. Medium technology industries are chemicals, plastics, and rubber. High technology industries comprised machinery, electrical and optical equiment, and transport equipment. Each insdustry is divided into three quality segments by ranging the products according to their unit values.NMS: Moving Up the Technology and Quality Ladder, 1994–2004
(Share in percent of country exports-LHS; UVR-RHS)
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Sources: Fabrizio, Igan, and Mody (2006).1/ UVR is the unit value of a country’s exports divided by the unit value of world exports. Expressed in logarithm so that a value of zero means country unit value equals world unit value.9. While the picture presented by the various REER measures is generally encouraging, it does not necessarily follow that the tradable sector is healthy. Instead, it could reflect a “survival of the fittest,” in which much of the tradable sector is buckling under severe competitive pressures, with declining market shares, and the “benign” REER developments merely reflect a shifting in the composition of exports toward those that are able to survive. It is important, therefore, as Lipschitz and McDonald (1992) argue, to supplement the standard REER measures with an examination of market shares and other indicators of sectoral developments. Estonia’s WEO-based export share developments indicate that it has actually increased its market share, especially in the last few years, in part assuaging these concerns (Figure 7).
Estonia: WEO-Based World Trade Shares, 1995–2005
(2000 = 100)
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Sources: WEO database (Winter 2006); and staff calculations.10. Moreover, the share of industry in the economy has grown in Estonia, as in most NMS (suggesting that the tradable sector growth is outpacing overall growth), while it is declining in the EU15’s economy. Economic growth in the NMS has outpaced that in the EU15 over the last decade, and, with the exception of Hungary and Latvia, their industrial sectors have exhibited an even larger relative expansion (Figure 8). The tradables sectors’ command of a rising share of resources is consistent with higher relative profitability, as predicted by Bems and Hartelius (2006), suggesting adequate external competitiveness.
Estonia: Relative Output Developments, 1995–2006
(2000 = 100)
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
Sources: European Commission; and staff calculations.11. In sum, the evidence suggests that Estonia’s external competitiveness is presently adequate. However, as discussed in section E below, growing macroeconomic overheating pressures, reflected in rising inflation in nontradables, pose a risk that the trend shift of resources into the tradeables sector may come under pressure.
C. External Adjustment Requirements
12. Although the export sector is presently competitive, Estonia’s current account deficit is too large to be sustained over the medium term, since external obligations are rising faster than GDP. Stabilizing the ratio of external obligations to GDP will require a shift in the net export position—and in its counterpart, the domestic saving/investment balance. The magnitude of the required external adjustment depends on a number of factors, including the pace of economic growth, the return on external obligations, and the level at which the external stock position stabilizes as a share of GDP. While growing interest and dividend payments increase the current account deficit and the negative NIIP, economic growth reduces the relative burden of the NIIP. It can be shown that the change in the economy’s NIIP position relative to GDP evolves according to the following equation:
where PCA is the primary current account deficit, i is the effective net nominal interest rate (including dividends for FDI) on external claims and obligations, and g is the economy’s nominal growth rate.4 When the NIIP share is stabilized, the equation can be rewritten as:
Stabilizing the NIIP to GDP ratio requires a primary current account balance that is large enough to offset NIIP servicing obligations, adjusted by the economy’s growth rate. The higher the debt service the stronger is the primary current account required to stabilize the NIIP ratio. On the other hand, the higher is the economy’s long-term growth rate, which acts to reduce the NIIP ratio by increasing the economy’s size, the lower is the required adjustment. The table below shows the adjustment in the primary current account required for Estonia for various combinations of “interest rate-less-growth rate” factors and the stabilized NIIP ratio. Under current conditions, an NIIP ratio of 100 percent of GDP and (i − g) equal to about -2¼ percentage points on average over the last decade (owing to strong growth and low interest rates), an improvement in the primary current account of only about 2¼ percentage points of GDP from an end-2005 deficit of 4.6 percent of GDP would be required to stabilize the NIIP ratio. However, were the (negative) NIIP ratio to increase, and were the “interest rate-less-growth rate” differential to increase (both likely outcomes), the amount of required adjustment would be larger, perhaps 5–10 percentage points of GDP.
Primary Current Account Adjustment Needed to Stabilize the NIIP
(percentage points of GDP)
Citation: IMF Staff Country Reports 2006, 419; 10.5089/9781451812510.002.A001
13. The ease of effecting the needed shifts in the net export position will depend largely on the economy’s growth potential and the flexibility of its factor and product markets. If past borrowing has been invested profitably, then one should expect to see a smooth reduction in investment rates as capital-output ratios approach those in the rest of the EU. Similarly, household saving rates should begin to rise with rising incomes in order to repay earlier borrowing for consumption smoothing. This is apparent in the Baltic-calibrated model of Bems and Hartelius (2006), which suggests that trade balances should become positive around 2010. However, continued high investment in Estonia, including in residential construction, spurred in part by low interest rates, and rapid import growth associated with economic overheating may be delaying the projected improvement in the trade balance. Nevertheless, eventual shifts of resources will be easier the more flexible are product and factor markets. In addition, continued strong growth will both help to reduce the scale of NIIP servicing obligations, and reduce the need to shift resources out of the nontraded sector, which would simply need to grow less rapidly than the tradable sector.
D. Institutions and Flexibility
14. International comparisons and Estonia-specific studies suggest that its labor and product markets are flexible, easing the transfer of factors of production in response to evolving opportunities, and facilitating rapid real income convergence.
Product Markets
15. Estonia ranks favorably on institution-based measures of the competitiveness of the business climate (Table 1). On many measures, Estonia ranks in the top half of EU25 economies, and among the best of the NMS. For some of the component rankings, Estonia’s high scores may be attributable as much to efficient government activities as to enterprise efficiency (e.g., low licensing requirements and the ease of paying taxes—where many are now effected electronically). In some areas where Estonia ranks less highly, the rankings are puzzling. Business startup and closing regulations appear to be comparatively onerous on the basis of these rankings. However, Masso, Eamets, and Philips (2004a) document high rates of firm turnover (the sum of entry and exit rates) by international standards, higher even than in the United States, suggesting that startup and closing regulations have not been unduly burdensome in practice.5 Similarly, while Estonia comes out as a negative outlier in hiring and firing costs, its high job turnover (discussed below) would suggest that these costs are not decisive. A third anomalous finding is that bank credit is difficult to obtain—Estonia ranks sixth among the ten NMS. This is difficult to understand in light of 65 percent growth in bank credit to nonfinancial enterprises in 2005–06.
Estonia: Selected Institutional Competitiveness Indicators
European Union (EU) new member states.
Tied with Austria, Finland, and the Netherlands.
Tied with 16 other economies, including Belgium, Slovenia, and France.
Tied with 12 other economies, including Portugal.
Estonia: Selected Institutional Competitiveness Indicators
| Overall | Among | Among | Total | ||
|---|---|---|---|---|---|
| Ranking | EU25 | NMS10 1/ | Ranked | ||
| Institution | |||||
| Institute for Management Development 2006 | |||||
| Overall | 20 | 8 | 1 | 61 | |
| Economic performance | 12 | 4 | 1 | 61 | |
| Government efficiency | 11 | 4 | 1 | 61 | |
| Business efficiency | 22 | 8 | 1 | 61 | |
| Infrastructure | 35 | 17 | 3 | 61 | |
| World Economic Forum 2006 | 25 | 11 | 1 | 125 | |
| Fraser Institute Economic Freedom of the World | 12 2/ | 4 2/ | 1 | 132 | |
| Heritage Foundation 2006 | 7 | 4 | 1 | 164 | |
| Transparency International Corruption Perception | 27 | 15 | 2 | 159 | |
| IBRD Doing Business in 2007 | 17 | 7 | 2 | 175 | |
| Starting a business | 51 | 11 | 3 | 175 | |
| Dealing with licenses | 13 | 2 | 1 | 175 | |
| Employing workers | 151 | 19 | 8 | 175 | |
| Registering property | 23 | 7 | 3 | 175 | |
| Getting credit | 48 3/ | 15 | 6 | 175 | |
| Protecting investors | 33 4/ | 5 | 1 | 175 | |
| Paying taxes | 29 | 4 | 1 | 175 | |
| Trading across borders | 6 | 3 | 1 | 175 | |
| Enforcing contracts | 20 | 9 | 4 | 175 | |
| Closing a business | 47 | 16 | 4 | 175 | |
| IBRD Governance Indicators 2005 | |||||
| Voice and accountability | 31 | 17 | 4 | 208 | |
| Political stability | 70 | 16 | 8 | 213 | |
| Government effectiveness | 37 | 14 | 2 | 210 | |
| Regulatory quality | 19 | 9 | 1 | 203 | |
| Rule of law | 49 | 16 | 3 | 208 | |
| Control of corruption | 41 | 13 | 2 | 204 | |
European Union (EU) new member states.
Tied with Austria, Finland, and the Netherlands.
Tied with 16 other economies, including Belgium, Slovenia, and France.
Tied with 12 other economies, including Portugal.
Estonia: Selected Institutional Competitiveness Indicators
| Overall | Among | Among | Total | ||
|---|---|---|---|---|---|
| Ranking | EU25 | NMS10 1/ | Ranked | ||
| Institution | |||||
| Institute for Management Development 2006 | |||||
| Overall | 20 | 8 | 1 | 61 | |
| Economic performance | 12 | 4 | 1 | 61 | |
| Government efficiency | 11 | 4 | 1 | 61 | |
| Business efficiency | 22 | 8 | 1 | 61 | |
| Infrastructure | 35 | 17 | 3 | 61 | |
| World Economic Forum 2006 | 25 | 11 | 1 | 125 | |
| Fraser Institute Economic Freedom of the World | 12 2/ | 4 2/ | 1 | 132 | |
| Heritage Foundation 2006 | 7 | 4 | 1 | 164 | |
| Transparency International Corruption Perception | 27 | 15 | 2 | 159 | |
| IBRD Doing Business in 2007 | 17 | 7 | 2 | 175 | |
| Starting a business | 51 | 11 | 3 | 175 | |
| Dealing with licenses | 13 | 2 | 1 | 175 | |
| Employing workers | 151 | 19 | 8 | 175 | |
| Registering property | 23 | 7 | 3 | 175 | |
| Getting credit | 48 3/ | 15 | 6 | 175 | |
| Protecting investors | 33 4/ | 5 | 1 | 175 | |
| Paying taxes | 29 | 4 | 1 | 175 | |
| Trading across borders | 6 | 3 | 1 | 175 | |
| Enforcing contracts | 20 | 9 | 4 | 175 | |
| Closing a business | 47 | 16 | 4 | 175 | |
| IBRD Governance Indicators 2005 | |||||
| Voice and accountability | 31 | 17 | 4 | 208 | |
| Political stability | 70 | 16 | 8 | 213 | |
| Government effectiveness | 37 | 14 | 2 | 210 | |
| Regulatory quality | 19 | 9 | 1 | 203 | |
| Rule of law | 49 | 16 | 3 | 208 | |
| Control of corruption | 41 | 13 | 2 | 204 | |
European Union (EU) new member states.
Tied with Austria, Finland, and the Netherlands.
Tied with 16 other economies, including Belgium, Slovenia, and France.
Tied with 12 other economies, including Portugal.
Labor Markets
16. Estonia’s labor market institutions promote considerable flexibility. These measures include time-limited, job search-conditional, and relatively low unemployment benefits, minimum wages set low enough relative to average earnings to not price out low-productivity workers, flexible wage bargaining to reflect individual/regional idiosyncrasies (often best achieved through firm-level bargaining), and less demanding employment protection legislation. Tables 2 and 3 present internationally comparable data on minimum wages and unemployment benefit systems, suggesting that the institutional setting supports labor market flexibility in Estonia. Minimum wages, while they have increased in the last decade, are still the second lowest (as a share of average gross wages) in the EU (after Spain). Unemployment benefits are among the lowest in the EU—while this ratio was increased in 2003, eligibility requirements were also tightened. As regards wage bargaining, Backé, Thimann and others (2004) report that, as in most other Central and Eastern Europe Countries (CEECs), wage bargaining occurs at the company level, minimizing risks that local conditions are not taken into account.6
Estonia: Minimum Wages as a Percent of Average Gross Wages, 1995–2004
2002.
2003.
2000.
Estonia: Minimum Wages as a Percent of Average Gross Wages, 1995–2004
| 1995 | 2001 | 2004 | |
|---|---|---|---|
| Belgium | 52 | 46 1/ | … |
| Czech Republic | 27 | 34 | 37 |
| Cyprus | … | … | … |
| Estonia | 26 | 29 | 34 |
| France | 47–48 | 47–48 | 46–48 2/ |
| Greece | … | … | 47 |
| Hungary | 31 | 39 | 36 |
| Ireland | … | 51 | 51 |
| Latvia | 31 | 38 | 38 |
| Lithuania | 28 | 44 | 38 |
| Malta | 52 | 43 | 44 |
| Netherlands | 48 | 45 | … |
| Poland | 41 | 37 | 36 |
| Slovak Republic | 34 | 40 | 41 |
| Slovenia | 41 | 41 | 44 |
| Spain | 42 | 35 3/ | 33 |
| United Kingdom | … | 37 | 40 |
2002.
2003.
2000.
Estonia: Minimum Wages as a Percent of Average Gross Wages, 1995–2004
| 1995 | 2001 | 2004 | |
|---|---|---|---|
| Belgium | 52 | 46 1/ | … |
| Czech Republic | 27 | 34 | 37 |
| Cyprus | … | … | … |
| Estonia | 26 | 29 | 34 |
| France | 47–48 | 47–48 | 46–48 2/ |
| Greece | … | … | 47 |
| Hungary | 31 | 39 | 36 |
| Ireland | … | 51 | 51 |
| Latvia | 31 | 38 | 38 |
| Lithuania | 28 | 44 | 38 |
| Malta | 52 | 43 | 44 |
| Netherlands | 48 | 45 | … |
| Poland | 41 | 37 | 36 |
| Slovak Republic | 34 | 40 | 41 |
| Slovenia | 41 | 41 | 44 |
| Spain | 42 | 35 3/ | 33 |
| United Kingdom | … | 37 | 40 |
2002.
2003.
2000.
Estonia: Main Features of Unemployment Benefit Systems in Central and Eastern European Countries
Not required if enrolled in a training course.
MLS (minimum living standard).
Effective 2003.
Unemployed earnings from casual work not more than half of the minimum wage per month remains entitled to full unemployment benefits.
Estonia: Main Features of Unemployment Benefit Systems in Central and Eastern European Countries
| Date | Reference period | Required min. | Max. duration of benefits | Relation to gross earnings (in percent) | Unemployment benefit levels (minimum and maximum, expressed in % of minimum wage) | ||
|---|---|---|---|---|---|---|---|
| minimum | maximum | ||||||
| Czech Republic | 1998 | 3 years 1/ | 12 months | 6 months | 50 first 6 months, 40 following 6 months (60 in case or retraining course) | None (but 70 of MLS if not employed before) 2/ | 150–180 of MLS |
| Estonia | 1995 | 1 year | 180 days | 6 months (3 months extensions considered on individual bases) | Flat rate - 60 of minimum wage | ||
| 2001 | 3/ 2 years | 1 year | 1 year | 50 in the first 100 days, 40 thereafter | 40 of average wage | 150 percent of average wage | |
| Hungary | 1997 | 4 years | 90 days | 1 year | 65 4/ | 90 of minimum old-age pension | 180 of minimum old-age pension |
| Latvia | 1993 | 6 months | 90 of minimum wage (70 for new entrants) | 70 of minimum wage | 140 of minimum wage | ||
| Lithuania | 1993 | 6 months | 70, later reduced to 60 and 50 | ||||
| Poland | 1997 | 18 months | 1 year | 18 months | Flat rate at 378.2 cz | None | None |
| Slovak Republic | 1997 | 3 years | 12 months | 12 months | 60 first 3 months, 50 following 9 months | None | None |
Not required if enrolled in a training course.
MLS (minimum living standard).
Effective 2003.
Unemployed earnings from casual work not more than half of the minimum wage per month remains entitled to full unemployment benefits.
Estonia: Main Features of Unemployment Benefit Systems in Central and Eastern European Countries
| Date | Reference period | Required min. | Max. duration of benefits | Relation to gross earnings (in percent) | Unemployment benefit levels (minimum and maximum, expressed in % of minimum wage) | ||
|---|---|---|---|---|---|---|---|
| minimum | maximum | ||||||
| Czech Republic | 1998 | 3 years 1/ | 12 months | 6 months | 50 first 6 months, 40 following 6 months (60 in case or retraining course) | None (but 70 of MLS if not employed before) 2/ | 150–180 of MLS |
| Estonia | 1995 | 1 year | 180 days | 6 months (3 months extensions considered on individual bases) | Flat rate - 60 of minimum wage | ||
| 2001 | 3/ 2 years | 1 year | 1 year | 50 in the first 100 days, 40 thereafter | 40 of average wage | 150 percent of average wage | |
| Hungary | 1997 | 4 years | 90 days | 1 year | 65 4/ | 90 of minimum old-age pension | 180 of minimum old-age pension |
| Latvia | 1993 | 6 months | 90 of minimum wage (70 for new entrants) | 70 of minimum wage | 140 of minimum wage | ||
| Lithuania | 1993 | 6 months | 70, later reduced to 60 and 50 | ||||
| Poland | 1997 | 18 months | 1 year | 18 months | Flat rate at 378.2 cz | None | None |
| Slovak Republic | 1997 | 3 years | 12 months | 12 months | 60 first 3 months, 50 following 9 months | None | None |
Not required if enrolled in a training course.
MLS (minimum living standard).
Effective 2003.
Unemployed earnings from casual work not more than half of the minimum wage per month remains entitled to full unemployment benefits.
17. Most studies find that labor markets are more flexible in CEEC economies than in other EU economies, with Estonia’s labor market among the most flexible. Ederveen and Thissen (2004) examine various aspects of labor market institutions, including unemployment benefits, active labor market policies, taxes, the role of unions, employment protection legislation, and minimum wages, and conclude that on balance the institutional setting is more supportive of flexible labor markets in the CEEC than in the EU15, with Estonia among the most liberal of CEEC economies. Backé, Thimann and others (2004) emphasize the need for labor market flexibility (including downward nominal wage flexibility) in an optimal currency area. They conclude that employment protection legislation (EPL) is less strict in the accession economies than in the euro area. They also note that nominal wage flexibility was apparent in some sectors in Baltic economies after the Russia crisis. They contend that Estonia and Hungary have the most flexible labor markets, because of weak EPL (in contrast to the assessment in Table 1), limited roles for trade unions, low levels of social protection, and high levels of wage flexibility.
18. Estonia-specific studies also find that the labor market is flexible. Haltiwanger and Vodopevic (2002) examine job turnover patterns during 1991–94, the initial period of economic restructuring. Job destruction at first far outpaced job creation, with a rapid rise in unemployment. In the latter part of this period, however, job destruction slacked off while creation picked up to about the same pace, with job reallocation (i.e., redundancies) accounting for slightly more than one half of worker reallocation, a pattern remarkably similar to that observed in the United States. Moreover, many transitions were characterized by job-to-job flows, rather than transitions through unemployment spells or periods outside the labor market.7 Masso, Eamets, and Philips (2004b) update Haltiwanger and Vodopevic’s analysis using data for 1995–99, and confirm that the patterns exhibited in the middle of the 1990s have persisted through the end of the century. Lehmann, Philips, and Wadsworth (2005) examine the 1989–99 period, and conclude that worker displacement rates fell rapidly to levels experienced in developed market economies shortly after the initial restructuring shock. Moreover, they found that Estonian displaced workers were quite similar to those in developed economies, disproportionately represented by the less skilled and those with short job tenures. Finally, about half of displaced Estonian workers found new jobs within two months, and there was less evidence of wage penalties for job losses than in some western economies.
E. Potential Risks and Future Challenges
19. Estonia’s restructuring and real convergence have been impressive, but these very successes are creating new challenges. Economic growth has recently surged, exceeding 10 percent in 2005, and is set to do the same in 2006, creating overheating pressures that could endanger external competitiveness and possibly divert resources needed to service growing external obligations. Moreover, recent research by Fabrizio, Igan, and Mody (2006) suggests that initial gains in export shares in the previous decade by NMS from restructuring and technological improvements were comparatively “easy” in light of low initial conditions, suggesting that continued “catching up” and economic convergence will require more intensified efforts.
20. Recent signs of economic overheating threaten to interrupt or even unwind the ongoing gradual shift of resources to the tradable sector. Interest rates in the euro area, to which Estonian rates are closely linked under the CBA, have been too low from a domestic perspective. This, combined with exuberant confidence, has led to economic expansion at a pace well above underlying potential, and a booming housing market. There is a risk that household expectations may become overly optimistic in projecting future increases in income, leading to excessive borrowing to smooth anticipated consumption paths. With cyclical unemployment largely exhausted, labor shortages may draw limited labor resources from the tradable sector. Moreover, pressures for wage increases in excess of productivity gains are rising, also threatening external competitiveness.
21. In addition, borrowing on the basis of expectations that are not subsequently borne out could lead to a protracted period of low growth, worsening the burden of servicing debt, and increasing vulnerabilities to unforeseen shocks. Borrowing that turns out to have been excessive could result in tepid domestic demand growth during the (possibly prolonged) interval while private sector balance sheets are restructured, as in Japan in the 1990s and more recently in Portugal.8 Despite Estonia’s high return to investment and its flexible product and factor markets, this possibility cannot be ruled out, as external shocks (such as sizable increases in natural gas prices, or contagion effects of shocks elsewhere) could alter perceptions of sustainability in light of Estonia’s large, and rapidly growing external liability position. The length and severity of such a downturn would depend in part upon the response of real wages to weak domestic demand, and the ease with which resources could be channeled to the relatively more vibrant tradeables sector. Thus, it remains important to limit the risks from overexuberant expectations through continued conservative macroeconomic policies, and to maintain the economy’s flexibility through liberal economic institutions.
22. Aside from cyclical considerations, it will be increasingly difficult to achieve continued convergence in living standards by climbing the technological ladder. Given Estonia’s worsening demographic prospects, with the working-age population set to begin declining in coming years, continued improvements in living standards will increasingly depend on technological improvements. Shifting comparative advantages and rising local wages, both natural results of economic convergence, threaten the competitiveness of sectors that depend on low wages. While Estonia’s shifting export composition has been comparatively impressive, continued gains will require dedicated efforts including continued investments in human capital. The educational system can be strengthened (especially at the vocational level) to meet rapidly changing employer demands. The level of research and development expenditures is also comparatively low. These shortcomings are identified and addressed in the authorities’ Action Plan for Jobs and Growth for implementing the Lisbon strategy. The proportion of university graduates should be increased (BNS 2006) in order to provide the basis for eventual increases in domestic research and development (R&D).9 These improvements would aid in competing with more technologically demanding trading partners.
F. Summary and Conclusion
23. Estonia’s CBA and supportive macroeconomic and structural policies have helped foster rapid increases in living standards, but continued convergence will be increasingly demanding. While high investment has come at the cost of rising external obligations that must be serviced, it has also boosted export capacity. Indeed, Estonia’s exports remain competitive, and are moving up the technology ladder, albeit with some reversals. Indicators suggest that product and factor markets are flexible, which should facilitate the further expansion of the tradable sector that is necessary to stabilize net external liabilities. While the progress to date has been smooth, a number of risks stemming from economic overheating deserve careful monitoring. Moreover, continued technological progress will require increased efforts to boost human capital. Estonia’s macroeconomic stability and flexible institutions provide an excellent foundation for meeting the challenge—it still will be important to preserve these achievements while fostering an environment where innovation and technological improvements can flourish.
References
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Prepared by Mark Lutz.
REERgdp and REERulcm are provided directly by the European Commission (2006a). REERind is constructed by the author, using Eurostat data for industry deflators for Estonia and the EU12. Industry deflators are used because those for the manufacturing sector, its largest component, are not available. EU12 measures are used because employment data, needed to calculate labor productivity data, are not available for the EU25 prior to 2000. However, as the correlation coefficient between the various REERs for the EU12 and EU25 ranges between 0.97 and 0.99, it would appear that this would not influence the conclusions discussed below.
While changes in export composition from climbing the technology ladder should be reflected in trend increases in the industrial deflator- and manufacturing unit labor cost-based REERs, taking their ratio should largely cancel out these trends, reflecting only changes in income shares in one economy compared to those in its trading partners.
The primary current account is defined as the current account less net income flows relating to net foreign financial claims. However, it also includes net capital transfers. See Lane and Milesi-Ferretti (2006) for a fuller discussion.
Masso, Eamets, and Philips (2004a) also note that Estonian entry and exit rates substantially exceed those in the Slovenian manufacturing sector. See also De Loecker and Konings (2003).
It is not possible to undertake a standard analysis of regional unemployment disparities in Estonia and the other Baltic states (as well as in Slovenia), as they are each one NUT2 region. County-wide unemployment rates do diverge in Estonia, and has generally been the highest in the northeast (Ida-Virumaa), an area where many firms were rendered uncompetitive with the demise of the CMEA trading system, and which is heavily populated by non-native Estonian speakers, In contrast, the unemployment rate is the lowest in the county containing the capital city. Nevertheless, the unemployment rate fell sharply in all but one county in 2005, with further reductions in the first half of this year, including in the northeast.
The authors contrast these patterns with those observed in Slovenia, where labor market institutions were much less conducive to rapid job creation and reallocations, and which experienced much lower rates of job-to-job transitions.
See Cardoso (2005) for a brief note on Portuguese developments.
Gros (2006) argues that a higher proportion of university graduates is a precondition for effectively increasing R&D spending. While Estonia’s R&D spending, at 0.91 percent of GDP in 2004 is above the 0.78 percent of GDP NMS average, it sizably lags the 1.92 percent of GDP EU15 average (Eurostat database). A similar picture emerges in examining the share of the employed engaged in R&D activities.
Appendix I: Data Appendix
Assets and liabilities of Eesti Pank, commercial banks, and leasing companies were derived from the central bank’s balance sheet and from the consolidated balance sheets of commercial banks and leasing companies. Assets and liabilities of the nonresident sector were derived from data on Estonia’s international investment position. All of these data are available online at http://www.bankofestonia.info/frontpage/en. Data on government assets and liabilities were provided by the Ministry of Finance and are on ESA 95 basis. Where needed, assumptions were made to classify the assets and liabilities by type of instruments. But the reliance on such assumptions was minimal because, overall, the data sources just mentioned provided reasonably sufficient information on breakdown by currency and by maturity.
The financial sector balance sheet data and the loans and deposits components of the data on the international investment position are compiled based on book value. Data on securities and equity investment are compiled based on market value to the extent that such information is available, otherwise book value is used. Therefore the matrices compiled in this paper mix the two types of data. Such a mix in the data is not uncommon in a balance-sheet study and is likely to be a caveat to the analysis in most studies implementing the balance sheet approach.
The nonbank private sector could not be broken down into a corporate sector and a household sector—but such a breakdown should be facilitated in any follow-up work by the data that Eesti Pank and the Statistical Office are planning to make publicly available in the near future.
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Prepared by Nada Choueiri.
By construction, the BSA—and, therefore, this paper—has two main shortcomings. First, it excludes nonfinancial assets, which implies that a sector’s net worth is underestimated. Second, and perhaps more importantly, it does not allow detecting within-sector vulnerabilities since intra-sectoral positions are consolidated out.
See Allen and others (2002) or Rosenberg and others (2005) for a more detailed background on using balance sheets to identify vulnerabilities.
Aside from the data used in this paper, Eesti Pank and the Statistical Office of Estonia compile two separate sets of financial accounts for Estonia, to be transmitted to the ECB and to Eurostat respectively. The Statistical Office publishes a partial set of these data on its website, and most recent data cover the period up to 2004 only, whereas Eesti Pank’s data are as yet unpublished. Both institutions plan on publishing the complete datasets on their websites in the near future.
Equity includes both direct investment and portfolio equity.
Data soon to be published by Eesti Pank (see footnote 4) reveals that nonfinancial corporations are responsible for the net liability position of the nonbank private sector, as households’ financial assets—the bulk of which is in the form of currency, deposits, shares and other equities—covered 133 percent of their liabilities at end-2005.
Equity investment data are recorded at market values. Thus both new flows as well as capital gains on existing stocks raise the stock of such investments. While estimates of this breakdown are not available, capital gains are believed to have been particularly significant in the banking sector in recent years—indeed, the market values of the shares of two major banks in Estonia were, as of end-2005, more than 5 times and 20 times higher than their respective book values.
This vulnerability is reduced, however, by the extent to which these are short-term deposits protected by the existing deposit insurance scheme or are deposits from parent banks.
In fact, in October 2005 some spreads became negative between kroon and euro denominated instruments.
Unfortunately, the data available was not sufficient to decompose the sectors’ foreign currency positions into positions in euros and positions in other currencies to better qualify the assessment of vulnerabilities stemming from foreign currency mismatches.
See Luna (2005) and Gray (2006).
Box 3 in IMF Country Report No. 06/379.
Differences in equity stocks between the two countries reflect in part that in Estonia equity of at least two major banks accrued large capital gains as noted in footnote 7, whereas in Latvia foreign banks are mostly unlisted (with FDI recorded at book values).
