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ECONOMIC POLICY 76: Small but free Estonia's economic reforms The problem: unpopular, unworkable controls Estonia, a small Baltic country with a population of only 1.5 million, suffered under the shackles of a Soviet-style state planned economy after it was annexed by the Soviet Union in the Second World War. After the fall of communism, how could the economy be reformed to encourage enterprise and efficiency? The idea: sweeping reforms Following independence in August 1991, the Estonian parliament pushed through a range of free-market reforms based on privatization, deregulation and a fundamental restructuring of the economy. Example: economic reconstruction As soon as it broke free of the Soviet Union, the government of Estonia decided to privatize enterprises and land as speedily as possible. Five early privatizations were completed in 1992. Privatization. An ambitious privatization programme was launched, based on the Privatization Law enacted in mid-1993. This has proved to be a highly successful piece of legislation, since the government has been able to apply it flexibly. The sale of assets, generally based on an open tender system, has been notable for its high degree of efficiency and the relative absence of corruption. Four methods of privatization have been employed:
Utilities and transport. The government broke up and privatized the monopoly public utilities that previously dominated the economy. Major Estonian companies such as the Narva Elektrivorgud power grid, the Eestil telecom network and Estonian Air have now been transferred to the private sector, either through public flotations or sales to new consortia of investors and managers. Estonia developed a regulatory system for public utilities such as electricity supply, based on the United Kingdom model. It features a price cap system for customer tariffs and quality of service safeguards. Capital markets. The Know-How Fund, a UK transition-aid programme, financed specialist advisers to Estonia on the development of capital markets and the establishment of investment funds. A stock exchange was created, in Tallinn, in 1996. The government coalition led by Prime Minister Mart Laar scrapped corporation tax, previously applied at 26 per cent, in a move to stimulate further investment. Balanced budget. Since 1999, the government of Estonia has adhered to balanced budget principles. Accelerating growth has helped to reduce the government budget deficit. The government also introduced a flat tax on company profits and personal incomes (see the chapter One Law for All) and abolished taxes on profits that were re-invested into the domestic economy, and introduced other, temporary tax holidays on company profit distributions. Banking system. Estonia has pursued the tricky task of laying down the foundations of a robust banking system. The former soft credits to inefficient enterprises, financed by the central bank and channelled through the banking system, have been discontinued. This has helped to establish stabilization of the economy as a whole. There has also been considerable foreign investment in the Estonian banking sector. Swedish investors have been particularly active, with Swedbank acquiring a majority stake in one of the five Estonian banks, Hansabank. Having taken over and merged two troubled banks in 1998, the government soon announced that it would sell its majority shareholding in the new bank, Optiva, to a Finnish banking group. Currency. The local currency, the Kroon, became pegged to the D-Mark at a fixed rate - an example of where a currency board has helped to promote a remarkable period of economic stability, based on importing another country's monetary policy (see the chapter Level Pegging). Trade. Estonia has been accepted as a member of the World Trade Organization, and despite some tariffs on agricultural produce (all within WTO bounds), it is essentially a duty-free trading economy. Results: more investment, lower inflation, higher growth Estonia has been highly successful at attracting foreign investment. In terms of the total per head of population, inward investment has been higher than anywhere else in Eastern Europe. Tighter monetary policy lowered the inflation rate from the rocketing level of 1000 per cent in 1992 down to a mere 3.9 per cent in 2000. The Russian financial crisis adversely affected economic growth in 1998-9. But despite this, Estonia was nevertheless enjoying an economic growth rate of more than 5 per cent. The driving force behind this improvement has been better labour and capital productivity gains, financed by foreign direct investment - the only means by which a country with a currency board system can grow. Assessment: a post-Soviet success In contrast to many other former Communist bloc countries, successive Estonian governments of different political hues have displayed a remarkable political consensus on the importance of implementing free-market reforms, based on free trade, the removal of subsidies and the curbing of state intervention in the management of enterprises. Privatization has been the main tool with which the country has attracted substantial foreign capital and modernized its industries and infrastructure. The political leadership has capitalized on the fact that the economy is relatively small and flexible. This small, former Soviet-bloc country shows that decades under communist rule does not prevent a rapid move towards a well functioning market economy. Estonia is now confidently looking forward to joining the European Union: negotiations began in 1998, and the country was selected as one of the 'first wave' transition countries for membership. For further information:
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Copyright 2002: Adam Smith Institute
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