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Estonia's success -how it could be sustained?

The role of productivity and flexibility

Andres SuttDeputy GovernorEesti Pank

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Outline1. The determinants of the productivity of Estonian firms2. The cornerstones of Estonian economic policy3. Flexibility of Estonian economy4. Challenges for the future

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Outline1. The cornerstones of Estonian economic policy2. The determinants of the productivity of Estonian firms3. Flexibility of Estonian economy4. Challenges for the future

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What is behind the success story? (I)

Currency Board regime - fixed exchange rate of kroon towards biggest trading partner (1992-1999 DEM, 1999-... EUR)

Strong fiscal policyBudget surplus in last five yearsVirtually no government debt (<5% of GDP)Transparent tax regime, “no exceptions” policyPressures arising from the aging tackled: fully-funded 3-pillar pension system

Liberal trading and investment regime since the reindependence in 1991

Equal treatment of local and foreign investors

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What is behind the success story? (II)Rapid privatization and restructuring

Including infrastructure, eg complete liberalization of telecom marketLevel of state aid one of the lowest in the EU

High level of foreign direct investment

Strong Nordic-owned financial sector

e-EstoniaTax reporting, e-Government, ...

EU member state since 1 May 2004

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Index of Economic Freedom 2006*1. Hong Kong2. Singapore3. Ireland

7. Estonia9. USA12. Finland19. Germany23. Lithuania38. Slovenia39. Latvia44. France122. Russia

•* Source: The Heritage Foundation

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Ease of Doing Business 2006*1. New Zealand2. Singapore3. USA

11. Ireland13. Finland15. Lithuania16. Estonia19. Germany26. Latvia44. France63. Slovenia79. Russia

* Source: The World Bank

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World Competitiveness Scoreboard 2006*1. USA2. Hong Kong3. Singapore

10. Finland11. Ireland20. Estonia26. Germany35. France45. Slovenia54. Russia

* Source: IMD

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The dynamics of Estonian GDP per capita by PPP compared to EU-25

0

10

20

30

40

50

60

70

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005* 2006* 2007*

Estonian GDP per capita by PPP, EU-25=100

Source: Eurostat

• Estonian economy (measured as GDP by PPP per capita) has experienced the fastestgrowth among the 25 EU member countries

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Outline

1. The cornerstones of Estonian economic policy2. The determinants of the productivity of Estonian

firms3. Flexibility of Estonian economy4. Challenges for the future

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GDP and labour productivity growth in Estonia

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

1998 1999 2000 2001 2002 2003 2004 2005

Labour productivitygrowthGDP growth

Source: Statistics Estonia

Annual real labour productivity growth exceeded 6 % in 1998-2005Annual GDP growth in new member states (EU-10) averaged 4% in 1998-2005,

while average productivity growth was 4,2%

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Firm and employment turnover in Estoniacompared to selected OECD countries

0

5

10

15

20

25

Finlan

dGerm

any

Canada

Portug

al

Italy

USA

Estonia

Firm turnover

Employmentturnover

Source: Estonia – Estonian Business Registry database, Masso et al (2005); other countries – Bartelsman et al. 2003.Note. For Estonia the numbers are the averages of 1995-2001; for other countries 1989-1994

Estonian economy has been characterised by relatively high firm and employmentturnover (exit+entry) rates, partially due to low administrative burden and low entry barriers

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Firm survival rates (left panel) and net employment gains (right panel) in Estonia

compared to the OECD countries

0.010.020.030.040.050.060.070.080.090.0

After 2 years After 4 years After 7 years

OECD

Estonia

00.10.20.30.4

0.50.60.70.8

After 2 years After 4 years After 7 years

OECD

Estonia

Source: Estonia – Estonian Business Registry database, Masso et al (2005); other countries – Bartelsman et al. 2003.

• New firms have high survival rates

• Surviving firms grow fast

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FDI dynamics in Estonia

0.0

5.0

10.0

15.0

20.0

25.0

1997 1998 1999 2000 2001 2002 2003 2004 20050.0

20.0

40.0

60.0

80.0

100.0

120.0

FDI inflow as % of GDP (left axis) FDI stock as % of GDP (right axis)

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FDI stock in Estonia by activity (as of end of 2005)

wholesale and retail trade

7.9%

m anufacturing13.6%

real estate, renting and bus iness activities

15.6%

others10.3% finance

47.4%transport, s torage and

com m unication3.0%

electric ity, gas and water supply

2.2%

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FDI stock in selected economies (% of GDP, 2004)

36.3

31.7

25.4

32.9

52.7

60.7

85.1

0 20 40 60 80 100

UK

EU

Poland

Latvia

Czech Republic

Hungary

Estonia

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The impact of FDI on the productivity of Estonian companies

Both inward and outward FDI are associated with higher totalfactor and labour productivity, wages and capital intensity of firms

Causal effects from FDI to higher productivity and vice versa

Significant self-selection effects found, more productive firms are more likely to engage in FDI or receive FDI

Positive effects of FDI on the subsidiaries seem to dominate overthe spillover effects to the rest of firms

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The impact of FDI, innovation and competition on theproductivity of Estonian companies

Both innovation and knowledge diffusion via FDI are importantdeterminants of productivity growthInnovative firms (with product or process innovation) have higher total

factor productivity than othersHowever, the effects of FDI (diffusion of existing knowledge) seem to be

larger than the effects of innovation

Competition improves the productivity of firms - higher localproduct market competition has a positive effect on the total factorproductivity of Estonian firms

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Outline

1. The cornerstones of Estonian economic policy2. The determinants of the productivity of Estonian firms3. Flexibility of Estonian economy4. Challenges for the future

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Inflation dynamics in Estonia and EU

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

1999 2000 2001 2002 2003 2004 2005

European Union Estonia

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Flexibility of price-setting (I): frequency of price changes per year

Number of price changes EURO AREA(2) EE>= 4 14 18 2 - 3 20 25

1 39 43<1 27 14

Median 1 1

Notes: % of firms; (2) Weighted average (GDP weights).

• Price changes are more frequent in Estonia than in the euro area countries

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Flexibility of price-setting (II): speed of price adjustment after shock

H ig h e r d e m a n d L o w e r d e m a n d H ig h e r c o s ts L o w e r c o s tsE u ro A re ale s s th a n o n e m o n th 2 2 2 6 2 4 2 2o n e to th re e m o n th s 3 2 3 9 3 4 3 4m o re th a n th re e m o n th s 4 6 3 5 4 2 4 4

H ig h e r d e m a n d L o w e r d e m a n d H ig h e r c o s ts L o w e r c o s tsE s to n iale s s th a n o n e m o n th 6 3 6 6 5 1 5 2o n e to th re e m o n th s 2 0 1 9 2 4 2 6m o re th a n th re e m o n th s 1 7 1 4 2 4 2 2

Notes: Percent of firms.

• The speed of price adjustment after shocks is higher in Estonia than in the euro area countries

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Estonian labour markets (I): institutional frameworkEmployment and unemployment rates in Estonia and European Union - 25, 2005Q3

Employment rate Unemployment rateEuropean Union - 25 64% 8%Estonia 65% 7%

•Trade unions: The share of workers in trade unions one of the lowest in the EU (ca 10 %) •Minimum wage: The ratio of the minimum and average wage 32%•Employment protection: The extent of employment protection close to theaverage in the EU countries•Unemployment insurance and benefits: Unemployment insurance somewhat and unemployment benefits significantly lower than the average in the EU countries•Taxation of labour: Relatively high in international and regional comparison (proportional income tax 23%, social tax paid by employer 33%).

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Estonian labour market (II): the measures of effectiveness• The flexibility of wages: after the Russian crisis (1998-1999) wages in

the tradable sector exhibited downward flexibility (both in real and nominal terms).

• The gross flows of workers (employment turnover): in internationalcomparison very high in the first half of 90s; later the employmentturnover has decreased but remains relatively high.

• The mobility of workers between sectors: in international comparisonvery high in the first half of 90s.

• The international mobility of workers: both inward and outwardmigration relatively low

• The mismatch between the education and required qualifications :the self-reported data of over- and undereducated workers are low ininternational comparison but challenges exist

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Outline

1. The cornerstones of Estonian economic policy2. The determinants of the productivity of Estonian firms3. Flexibility of Estonian economy4. Challenges for the future

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The biggest medium-term challenge for Estonian economy is ...

... maintaining competitiveness

Support from the institutional frameworkEuro adoption, simple tax regime, responsible public sector, ...

Flexibility of labour marketRetraining, demographic challenges, ...

Shift towards higher value-added production and servicesEducational priorities, FDI-related knowledge spillover, innovation, ...

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Recent economic forecast by Eesti Pank (spring 2006)

2006 2007 2008Real GDP growth (%) 8,1% 7,6% 6,9%Consumer price inflation (%) 3,6% 3,0% 3,7%Current account (% of GDP) -9,6% -9,4% -9,0%Real investment growth (%) 11,9% 8,6% 7,6%Real export growth (%) 15,0% 14,1% 12,5%Real import growth (%) 15,1% 13,7% 12,2%Unemployment rate (%) 7,0% 6,4% 6,2%Real wage growth (%) 8,3% 7,1% 6,7%

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Concluding remarks• During last ten years Estonian economy has experienced strong

economic growth• Economic performance has been supported by:

institutional framework: liberal market economy; constrained government; transparency of rules; outlook for the EU and euro area membership

high integration to the EUstrong competitive pressures in most sectors strong and effective financial sectorhigh FDI inflows, low entry barriersrelatively low administrative burdenhigh price flexibilityeffective labour markets, nominal wage flexibility

• The key challenge is to maintain competitiveness by furtherdeveloping Estonian economic policy framework