AGENDA FOR EUROPE:WHICH OF ESTONIA’S SUCCESS FACTORS CAN BE USEFUL FOR OTHER EUROPEAN COUNTRIES AND THE EUROPEAN UNION

Ardo HanssonEesti Pank5 April 2014

What are the features that have led to success in Estonia’s economic development?

a) Strong economic growth over the last 20 years

b) Resilience to adverse shocks, especially during the global economic and financial crisis in 2008-09

c) Speedy adjustment and recovery in the aftermath of the financial crisis

At the same time, important insights for other countries may be gleaned from the less successful moments in Estonia’s economic development, especially from the unsustainable boom prior to the global crisis

(A) During the last 20 years Estonia has experienced strong economic growth

Average annual economic growth 1996-13 (%) GDP per capita in PPS 1996-2013 (EU-28=100)

Source: Eurostat

0

1

2

3

4

5

6

European Union (28countries)

Euro area (18countries)

Central/EasternEuropean (11

countries)

Estonia

0

20

40

60

80

100

120

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

European Union (28 countries)

Euro area (18 countries)

Estonia

Determinants of Estonia’s economic growth

Source: World Economic Forum Global Competitiveness Report 2013-14

Rank Rankout of all 148 countries out of EU-28

Global Competitiveness Index (total) 32 12

Basic requirements (21.7%) 26 11Institutions 27 11Infrastructure 40 19Macroeconomic environment 22 3Health and primary education 29 15

Efficiency enhancers (50.9%) 30 13Higher education and training 23 10Goods market efficiency 30 12Labour market efficiency 12 2Financial market development 35 9Technological readiness 29 15Market size 99 26

Innovation and sophistication (28.3%) 35 14Business sophistication 51 18Innovation 31 13

However, Estonia experienced an unsustainable boom prior to the global financial crisis, followed by a severe recession

The boom in 2004-2007 was accompanied by: 1) large current account deficits/capital inflows; 2) strong credit growth; 3) rapid increases in asset prices;4) deterioration in cost/price competitiveness.

Economic growth, current account balanceand unit labour costs

Loan growth and change in real estate prices (%)

Source: Eurostat, ECB

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Economic growth (%)Current account balance (% of GDP)ULC-REER (%)

-40%-30%-20%-10%

0%10%20%30%40%50%60%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Loan growth Change in real estate prices

(B) During the severe recession the Estonian economy showed a high degree of resilience

Cumulative decline (peak to trough) in GDP in selected euro area countries in 2007-2013 (%)

Despite a very severe recession in 2008-09 Estonia did not experience a systemic financial crisis and did not need to apply for international financial assistance

-30%

-25%

-20%

-15%

-10%

-5%

0%

Estonia Latvia Greece Ireland Portugal Cyprus Spain

Source: Eurostat

Factors of resilience (I):Lower levels of private and public sector indebtedness

0

20

40

60

80

100

120

140

2007 2013

Euro area

Estonia

0

10

20

30

40

50

60

70

80

90

100

2007 2012

Euro area

Estonia

Bank credit to households and firms (% of GDP) Public sector debt (% of GDP)

Source: Eurostat, ECB

Factors of resilience (II):well-capitalised banks;limited size of the financial sector

Ratio of capital and reserves to total assets (%) Ratio of MFI total assets to GDP (%)

Source: Eurostat, ECB

-

50

100

150

200

250

300

350

2007 2013

Euro area

Estonia

0

2

4

6

8

10

12

14

16

18

2007 2013

Euro area

Estonia

(C) Speedy adjustment and recovery:GDP and unemployment

75

80

85

90

95

100

105

t0 t2 t4 t6 t8 t10 t12 t14 t16 t18 t20

Estonia

EA-4

0

5

10

15

20

25

t0 t2 t4 t6 t8 t10 t12 t14 t16 t18 t20

Estonia

EA-4

GDP after the cyclical peak in 2007-08 (GDP at cyclical peak=100; quarterly data)

Unemployment (%, t0 = cyclical peak in GDP during 2007-08; quarterly data)

Note: EA4 consists of Ireland, Greece, Spain and Portugal

Source: Eurostat

Speedy adjustment and recovery:External and fiscal adjustment

Current account balance (% of GDP) Fiscal balance (% of GDP)

Source: IMF, World Economic Outlook Database, October 2013

-20

-15

-10

-5

0

5

2007 2008 2009 2010 2011 2012 2013

Estonia

EA-4

-16

-12

-8

-4

0

4

2007 2008 2009 2010 2011 2012 2013

Estonia

EA-4

Speedy adjustment and recovery:Deleveraging

Net international investment position (% of GDP) Loan to deposit ratio (%)

Source: Eurostat, ECB, Eesti Pank

0

50

100

150

200

250

2007 2012

Estonia

EA-4

-120

-100

-80

-60

-40

-20

0

2008 2013

Estonia

EA-4

Speedy adjustment and recovery:the role of wage flexibility and productivity growth

90

95

100

105

110

115

120

2008 2009 2010 2011 2012 2013

Real unit labour costs Nominal output per person empoyed

Nominal wage costs per employee

Real unit labour costs, whole economy (2008=100)

Source: Statistics Estonia

Cost competitiveness was mostly restored via strong productivity growth and to a lesser extent via downward (nominal) wage adjustment.

Fiscal consolidation in Estonia in 2008-2010

Fiscal consolidation in Estonia was front-loaded (consolidation measures amounted to about 10% of GDP: 2/3 on the expenditure side and 1/3 on the revenue side).

The fiscal consolidation strategy had the following components:1) Protection of the most vulnerable groups;2) Broad-based reductions in current expenditures;3) Reduction of wages in the public sector;4) The phasing in of structural reforms.

0%

5%

10%

15%

20%

25%

30%

35%

40%

2008 2009 2010

Social protection (% of total government expenditure)

Social protection (% of total government expenditure)

Headline and structural budget balance (% of GDP)

Source: Eurostat, Eesti Pank

-8%

-6%

-4%

-2%

0%

2%

4%

2007 2008 2009 2010 2011 2012

nominal budget balance structural budget balance

14

The advantages and disadvantages of a sharp adjustment rather than a gradual one

Disadvantages of a sharp adjustment:- an overreaction might force ‘viable’ firms out of business, leading to losses in physical and human capital;- it is politically difficult if the electorate is not informed or is reluctant;- the high speed of adjustment might lead to mistakes in economic policy.

Advantages of a sharp adjustment:- a shorter period of high uncertainty weighing on economic activity, especially on investment decisions;- faster closure of ‘non-viable’ firms and elimination of unsustainable businesses and activities- avoidance of reform fatigue;- avoidance of excessive accumulation of public and private debt.

What can be learned from the unsustainable boom in Estonia before the global financial crisis?

1. A strong external anchor in the form of a credible fixed exchange rate arrangement might lead to policy complacency

2. The build up of imbalances and vulnerabilities created by the amplification channels of the economy needs to be addressed early and decisively (e.g. through more active use of fiscal and macro-prudential measures). Under a fixed exchange rate regime/monetary union some of these channels might be especially strong (e.g. the real interest rate channel associated with the asset price/credit channel)

3. Overall, the experience of the euro area has demonstrated that in a monetary union there is indeed a stronger need for policy discipline in other economic policy areas

Which of Estonia’s success factors can be useful for other EU countries

Estonia has been successful thus far in ensuring relatively high growth and strong resilience in the economy. Both of these achievements have been strengthened by:

- Strong fiscal policy discipline;- Flexible labour markets;- Relatively low levels of indebtedness (especially public sector

indebtedness);- Well capitalised banks and the limited size of the financial sector;- Extensive sustained structural reforms;- Strong and prompt policy responses to adverse shocks.