Global Economics

Estonia: The Baltic Exception


Quick moves, a rainy-day fund, and close ties to Scandinavia set this Baltic nation apart from its neighbors when the crash came—and helped it recover faster

It sometimes makes sense to lump together Estonia, Latvia, and Lithuania into a grouping called the Baltic states – when talking about their common 20th century experience of foreign domination, for instance, or, more recently, entry into NATO and the EU.

But in the most fundamental ways – histories, languages, and, now, economies – they are different. Nothing has shown that more clearly recently than Estonia's outpacing its neighbors as it climbs out of the financial hole of the worldwide recession.

"Estonia is recovering first because the economy was stronger in the beginning," said Heikki Maki, vice president of Elcoteq (ELQAV:FH), a Finnish electronics manufacturer operating in Estonia since 1992.

Maki said Estonia's quicker path to recovery justifies Elcoteq's decision to keep its Tallinn factory open.

"Estonia ran fiscal surpluses during the good years and built up a fiscal buffer," said Christoph Rosenberg, who is responsible for coordinating the IMF's policy advice to Estonia. "It did let down its guard a bit in the very last year of the boom by allowing expenditures to increase, but it was kept relatively under control, and the structural deficit was not as big as it could have been."

Neither Latvia nor Lithuania expects its economy to grow again until 2011. Latvia in particular has been ravaged by the financial crisis. Its coalition government fell apart in March, and since December demonstrators have been camped in downtown Riga, demanding the government take action against joblessness.

Estonia, however, has already begun to recover. The Finance Ministry predicts 1 percent growth in 2010, while SEB (SVKEF), a Nordic bank that does business in Estonia, predicts growth of 2 percent, soon to be followed by declines in unemployment and inflation. The situation is far from rosy, but Estonia is emerging from the crisis not only faster than the other Baltic countries, but also with a mix of prudence and optimism that will define its growth for years to come.

HARD CAPITALISM

Before World War II Estonia had a stable agricultural economy. Germany and England were the main markets until the country was taken over by the Soviet Union, an experience that devastated the economy and produced deep resentments in Estonian society.

After the fall of the Soviet Union, Tallinn immediately embraced capitalism. Price controls were lifted, welfare programs cut, and business regulations slashed. A flat income tax was introduced, and massive privatization occurred. Foreign direct investment in Estonia soon significantly outpaced that in Lithuania and Latvia, according to the UN Conference on Trade and Development. After joining the EU in 2004, Estonia's economy averaged about 8 percent growth every year. Real estate prices skyrocketed and easy loans from Swedish banks were available.

Beginning in 2008 however, the surging economic growth suddenly stopped. The country was overheating; it was suffering inflation and an oversupply of goods intended for a population that for the first time had money to spend. As the Baltic real estate bubble burst, internal spending dropped. GDP fell by 15 percent in 2009, one of the steepest contractions in the world.

Unemployment, which had been 5.7 percent in 2008, jumped to 14.3 percent in 2009.

"For me the emotional moment when I realized the severity of the crisis came in 2007," Finance Minister Jurgen Ligi said in a recent interview. "We were too optimistic. In society and in government."

When the deficit grew the following year, Tallinn was forced to acknowledge the severity of the crisis.

Then, however, the response was fast and decisive. The budget was cut, and VAT was increased from 18 to 20 percent. Worried that money injected into the economy would end up being stashed away in savings or leaving the country, the government did not try to stimulate the economy. Ligi admits that foreign expectations for Estonia's recovery were low.

Yet despite some internal squabbling and the current ruling coalition functioning as a minority government, Tallinn stuck by its commitment to an open economy, high transparency, and limited red tape. The country also refused to devalue the kroon, which might have helped shore up its exports but would have complicated its goal of adopting the euro next year.

"We were going to stick to the Maastricht criteria whatever it took," Ligi said. "We wanted to restore trust in the region. That was very important. That we restore the trust we've [had] for 15 years."

Earlier this month the European Commission said that Estonia had satisfied the Maastricht financial criteria and gave the green light for the country to join the eurozone in January. When asked why Estonia attracted more investment during the 1990s than the other Baltic countries, the unabashedly pro-Western Ligi responded, "We spoke better English. In Latvia they spoke better Russian, and in Lithuania more Polish and Russian."

The minister said the Baltic countries differ more than usually portrayed. Estonia, he said, is influenced more culturally and economically by Finland and Sweden, its main trading partners. Latvia is mostly influenced by Russia, and Lithuania by Poland. Nordic telecommunications and electronics companies and banks have invested heavily in Estonia since the fall of the Soviet Union.

Ligi said it is Estonia's orientation toward the wealthy and well-run Nordic economies and the investment and business they offer that allowed Estonia to develop more quickly than the country's southern neighbors and to recover from the financial crisis faster.

While Ligi is right that Estonia has a lot of investment from Scandinavia, so do Latvia and Lithuania. The country's success cannot be explained solely in terms of economic cross-pollination with the Nordic countries, but rather is likely a case of good management, learned from its neighbors to the north. "Thanks to an extraordinary effort at all levels of government, especially in the last months of the year, the 2009 fiscal deficit was contained well below the Maastricht limit," the IMF's Rosenberg said in a statement after a late-March visit to Tallinn.

Recovery began with an increase in exports, like the satellite phones made by Elcoteq, during the fourth quarter of last year. Unemployment only recently began a slight downturn and internal consumption is still low, but Ligi wants to increase exports instead of relying on the domestic market to keep the country's growth moving forward.

"Structural adjustment is key," he said. "We will create innovation and increase exports. The country is still very open. We can't be too closed if the attitude is to be positive."

Estonia's exports have grown 17 percent in 2010 over the same period last year, to 9.7 billion kroons (620 million euros). Seventy-six percent of Estonia's trade is with the EU, according to the state statistics office. Latvia and Lithuania also see exports as their way out of the crisis, but they have fewer high-value international producers, such as Elcoteq, which makes products for companies like electronics giant Ericsson.

Ligi said he doubts that the kind of boom that happened in Estonia will be possible again. "I am of course not against growth, but we have to be careful with balance. Society has become much more realistic. Everything has changed on all levels. The attitudes of the banks have changed. The attitudes of the government and the common people."

CHANGING ATTITUDES

If the bust has made many Estonians more cautious, it has given Harri Tidus an opportunity to be bold.

"These are the patients," he said, gesturing at a room full of classic cars in various states of disrepair.

Tidus quit his job as a restaurant marketing manager in August to start his Tallinn-based classic car restoration company, Autoklassic. He spoke of a "high stress factor" as dozens of restaurants and other businesses closed because of the crisis. His pay had been reduced in a series of cuts since the beginning of 2009. "For me it was a good time," he said. "The cost of real estate was low."

Only a year after registering his company, Tidus has moved into an insulated two-room workshop in an old paper mill a few minutes from Tallinn's old town. He is one of the few tenants with the cash flow to pay rent and has two full-time employees, whom he pays 320 euros a month. That is about half the salary workers with their skills would have commanded two years before, he said.

The signs of recovery in Estonia are strong enough that Tidus envisions an entire classic car enterprise, right down to the finishing touches. "When you don't have the gloves I want to be able to sell them to you," he said. Only the day before he had registered another company that will provide classic cars to three Tallinn hotels for guests to rent.

While admitting that his income comes in chunks from long-term restoration jobs that he prices on a case-by-case basis and more regularly from performing tune-ups, Tidus is optimistic because the severity of the global economic crisis seems to have taught Estonians some necessary hard lessons about spending money.

Before the crisis many people were for the first time celebrating their access to money and taking out loans to live in ways that before had been denied to them. Houses were being built across the country with expectations that their market price would climb every year. According to the Estonian central bank, the percentage of loans to the real estate industry went from 18 percent in January 2000 to hovering above 40 percent throughout 2007.

But not anymore.

"You see the change in the nightclubs," Tidus said. "Before people would go out and drink champagne. Now they drink at home and then go out. It is so expensive to drink in clubs."

Tidus said along with this newfound thriftiness has come a renewed appreciation of quality.

The new cafes and shops opening up in Tallinn, he said, are different than the ones opened during the boom years. "They have to be a little better than they were before. They have to give something to people. People want to see quality," he said.

For example, he said, a new café in the Kalamaja district of Tallinn, near a recently opened health food store, is trendy, but instead of targeting tourists, the cafe is for locals with prices half those typically charged in the old town.

"They are using more wisdom in how they invest their money," Tidus said. "You are thinking more when you begin spending money."


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