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Country Commercial Guides FY 2000: Estonia Report prepared by U.S. Embassy Tallinn, released July 1999 Note*

CHAPTER II. ECONOMIC TRENDS AND OUTLOOK

Major Trends and Outlook

Largely as a fallout of the Russian financial crisis, economic growth that was nearly 11 percent in 1997, fell to 4 percent in 1998 and is expected to be only 0.5 percent in 1999. However, experts believe that Estonia's economy has bottomed out, and forecast a reasonable and sustainable GDP growth of 4 percent in 2000 and 5-6 percent by 2001.

Estonia's economic downturn over the last two years is the country's first experience of the down side of normal economic cycles. It was not entirely unwelcome as it forced companies and consumers to recognize that slowdowns are inevitable, especially in small economies that have little control over external economic and political developments.

Despite these developments, Estonia's medium- and long-term economic outlooks remain excellent. In its brief history since regaining independence, Estonia has established some of the most radical economic and market reforms in Central and Eastern Europe and has steadfastly stuck with them.

Principal Growth Sectors

Services, especially transportation and tourism, will be the principal growth sectors for the next few years. Manufacturing and the forest products sector are also likely to continue to grow.

Transportation: Estonia's main ports are modern and relatively well-managed, enjoy low labor costs, are deep enough to allow the largest ships capable of operating in the Baltic Sea to berth and are generally ice-free. The privatization of the railroad linking Estonia's ports to Russia's Great October railroad is expected by the middle of 2000. New management and significant investment should bring a sharp increase in the railroad's capacity.

Tourism: Estonia's vibrant service sector contributed significantly to offsetting Estonia's deficit in trade goods. Tourism, especially the millions of Finns who come every year to Tallinn for shopping and pleasure, is expected to continue to show steady growth.

Manufacturing: The supply of components to Nordic companies will continue to show steady growth. The combination of dramatically lower costs and a highly trained workforce, reinforced by the past successes enjoyed by Finnish and Swedish companies operating in Estonia, will lead to investment in similar manufacturing and assembly plants.

Forest Products: The wood and forest products industry is also expected to grow steadily. More value-added manufacturing of the abundant timber, which is either harvested in Estonia or shipped in from Russia, will likely take place in Estonia itself.

Government Role in the Economy

The economic reforms in place in Estonia have limited the government's role in the economy to an extraordinary degree. Because of a balanced budget legal requirement and the use of the currency board system, the government has an extremely restricted range of instruments with which to influence the economy. With the Estonia kroon pegged to the German Mark at a ratio of eight to one, the size of Estonia's money supply is directly determined by the amount of foreign exchange it can attract through exports, loans, or investments. Beyond the constraints imposed by the legally mandated balanced budget, the government has been extremely reluctant to issue sovereign guarantees from international financial institutions, so much so that Estonia has an international public debt burden of about 5 percent of GDP.

The government has also restricted its role in government by avoiding import tariffs (except for agricultural products from certain third countries) and limiting excise taxes to a small range of products.

The legal requirement for a balanced budget has prompted Estonia to establish an offshore stabilization fund where it has deposited income above its expenditures and much of the revenue from privatizations, including a successful IPO for the telecommunications company. Despite the current budget shortfall, the government is extremely reluctant to draw on the stabilization reserves. Instead, the government has opted to deal with the 1999 revenue shortfall by deferring investments, preparing a negative supplementary budget that cuts spending, and by taking additional steps to cut expenditures.

Estonia has largely completed its privatization with only a few infrastructure enterprises still remaining under government control. In 2000, the privatization of the railroad, the power generating company, and associated oil shale mines are all due for completion. Virtually all other state-owned enterprises engaged in productive activities have been privatized. A small number of municipal-owned enterprises have yet to be privatized but these constitute a tiny fraction of the overall economy.

Balance of Payments

Estonia's small, open economy is constrained by its currency board system and can only grow by attracting foreign capital. In the mid-90s, Estonia's strong economic growth coupled with the need to extensively rebuild the economy resulted in current account deficits that reached as high as 12-13 percent of GDP. While the economic slowdown has narrowed this significantly, the current account deficits remain a concern. And while imports have continued to decline, so, too, have exports. Income from services and capital inflows in the form of foreign direct investment have remained strong.

Infrastructure

Telecommunications: The long distance telephone concession agreement the government made with a consortium of Swedish and Finnish firms, while controversial, has served the country well, with modern, in many cases, digital phone lines extended throughout the country. In areas where the population density was too low to warrant installation of fixed line systems, other wireless systems were installed. In addition to its fixed line system, Estonia has three mobile phone service providers and the country has the highest number of mobile phone users per capita in Central and Eastern Europe.

IT: Information technology has progressed quickly with Estonia having one of the highest number of Internet users in Central and Eastern Europe. The government has undertaken a major commitment to provide all schools in the country with Internet access.

Transportation: Surface transportation is satisfactory, although the road system is becoming increasingly taxed by the growing number of vehicles. The railroads handle a steadily growing amount of transit trade for Russia through Estonia's excellent, modern ports.

The bulk of transit cargo passes through the Tallinn's expanding ports. Unlike in Latvia, where the majority of petroleum products are transported from Russia via pipeline, nearly all of the petroleum transiting Estonia is hauled in railcars.

Energy: Estonia is self-sufficient in electrical power; its two large oil- shale power plants have a generating capacity of about 3000 Megawatts, twice Estonia's domestic demand. Because of its large oil shale reserves, Estonia does not need to rely on other sources for fuel. The power plants formerly produced and exported energy to Russia and Latvia, but these markets have largely disappeared. Negotiations are currently underway with a U.S. energy company to form a joint venture to renovate and operate the two oil-shale fired plants, at the same time bringing them into compliance with international environmental standards.