The Estonian way to approach the crisis

On 9 August 2011, just days after Standard & Poor’s downgraded the credit rating of the United States, it raised Estonia’s rating from A to AA-. S&P cited its confidence in Estonia’s ability to “sustain strong economic growth” among the factors contributing to its decision.  How can a rating agency trust a tiny country when the overall picture is worsening at such speed?

The reason is simple – a different (more strict) approach to public finances, and a favorable economic climate. Estonia is not influenced by the bond markets – the country simply does not have any government bonds issued and the government has reserves twice as big as the country´s overall debt level.

Keeping the budget in balance

When most of Europe is in deep debt and maintaining constantly high deficits, Estonian public debt is below 6% of GDP and its budget is in surplus (est. 1.7% in 2011). Both figures place it at number one in the EU, with the debt itself being lower than several countries´ annual deficit. In other words, the country is spending only as much as it can afford.

Only a few years ago, most politicians from around the EU spoke about stimulus. What they really meant was spending more public money in the hope of buffering economic decline – the inevitable consequence of the economic crisis. This resulted in continuing the awful trend of living wealthier than was affordable – most of the countries had borrowed themselves a better living standard. It seems that nobody thought about when they would have to pay back old debt (with interest, of course). No wonder that Greece, a country with just 30% higher GDP per capita than Estonia, cannot afford 2 or 3 times bigger salaries and pensions than Estonia (not mentioning the effectiveness of collecting taxes etc.). Once borrowed, the living standard now needs to come back to the real world.

It is remarkable that only 4 countries out of 27 (EE, LU, SWE and FI) have their public finances in order according to the officially agreed EU-criteria. 3 of the 4 are close to each other both geographically and trade-wise, which means that growth in one generates growth in the others as well. Estonia being one of the Nordic countries clearly helps it´s real economy.

Being small and open to trade also means being vulnerable to international impacts – in 2009 Estonia faced one of the biggest economic declines in Europe: GDP fell by 14.3%.  Instead of trying to keep public expenditures at the same level, the Estonian government and parliament decided to cut public costs in order to let the economy breathe more freely. As there was a strong surplus of close to 3% before the crisis in 2007 (a year when the Estonian economy grew very quickly), it was relatively easy to make the cuts. But it still meant cutting both jobs and salaries in the public sector (the same was done by private sector companies as a necessity to survive the crisis) and it resulted in a more effective and dynamic government.

The years 2008 and 2009 were also used to make several structural reforms – a “good crisis” being the best time for politicians to make needed, but in the short run unpopular decisions. The labor law was changed to be a lot more flexible, the tax system was made even more effective and the retirement age was raised by 2 years in order to address demographic realities. The general idea was to come out of the crisis stronger and more effective. This is something politicians usually tend to avoid – it is generally much easier to offer new bonuses to different voter groups.

Favorable business climate and the euro

Estonia was also among the first to start growing again (2010 resulted in 2.3% growth) and is expecting the highest growth rate in the EU in 2011 (around 8% real growth). Exports are growing above 20% annually for the second year in a row (after an 18.6% decline in 2009) and unemployment, that went up to 16.9% is coming down at an equally fast speed and has already declined to less than 12%.

When most of the EU is in crisis, one can say that Estonia is already on the next growth cycle. It also means a lot of new investment (partly because of the favorable and predictable economic policies, and partly due to becoming a member of the euro-zone).

Yes, you read that right. Becoming a member of the euro-zone is considered a big plus in Estonia – mainly because having a currency used by a number of your trade partners (including Finland as the biggest export destination) reduces any kind of exchange risk. On a personal level it means that Estonian households have their incomes and liabilities in the same currency – the banks have issued loans and leases in euro for years. It has also meant that Estonians have already been enjoying very low interest rates before using the euro. It is widely known in Estonia that the kroon was linked to the euro at a fixed exchange rate and it remained from the start of the euro till the end of the kroon at exactly 15,6466. So, if you knew that (and you did), then there should have been no currency (exchange rate) risk in the first place? Yes and no – the biggest investors in Estonia are Finns and Swedes, both remembering that in their homelands devaluation has been part of recent history. You might tell them 1000 times that the Estonian system is different, but there were always suspicions. So, all in all the decision to join euro brought lots of new investment.

Investment is not the only important way to create jobs. It is also good for the economy to reach the next level – Estonia has moved from a cheap labor, low-and-value-adding economy to be a much more knowledge-based economy. Foreign direct investment, economic and education policies etc. are all contributing to this goal. The ambition is high – Estonians still remember that before war and occupation the country´s GDP per capita was even a little bit higher than Finland´s and just below Sweden´s. In order to regain this position, things have to be done in the best possible way.

An abridged version of this article was published in Kauppalehti (31.01.12): Viron talous tasapainottuu talouskriiseistä huolimatta.