Eesti Pank - Bank of Estonia

The European Union is a very large, very rich, and very powerful economic union an it will remain so for a long time. There is nothing very much wrong with the EU as it is - even if, at the moment, it seems to be standing still, while other, more dynamic regions of the world speed along. The question is, will that be enough for our future generations?

The European Union is currently facing several complicated economic policy problems that have their roots in its recent history. The new member countries will bring along with them some new weaknesses - but, hopefully, they will add some new strengths. Working together, we should be able to create a continuously strong, flexible, and efficient economic area. To achieve that, a strong and modern financial sector in every member country, as well as an efficient common market for financial services, is a must.

By adopting the growth initiative in 2003 the EU took an important step towards achieving an important goal -speeding up long-term economic growth. It is very important continue taking steps to improve the functioning of the common market and increase efficiency through a higher level of infrastructure investments, closer attention to innovation, and an expanding knowledge base.

For the last 3 years Europe's economic growth potential has not been realized. A relatively weak growth with a strong dependence on the external environment and low domestic demand on the one hand and a relatively rigid inflation level on the other hand would seem to indicate the necessity of carrying out some structural reforms in the present member countries, while continuing similar reforms in the new member countries.

The flexibility and mobility of production factors, especially capital and labour market flexibility, should be encouraged as vigorously as possible. The importance of the efficient use of resources in the common market economies cannot be stressed strongly enough. According to the Optimum Currency Area theory the need for nominal exchange rate adjustments is lower if wages and prices are flexible (especially downwards) and/or production factors are mobile across and within countries. It might be interesting to note in this context that wages in Estonia have demonstrated downward flexibility and during the adverse shock of the Russian crisis in 1998 even nominal wage flexibility in some sectors.

The importance of a flexible labour market of the effectiveness of the common monetary policy is an issue that tends to get less attention than it perhaps should. However, despite some fears to the contrary it is unlikely that Europe will see a very notable cross-border migration of the labour force in the near future - even after the EU enlargement. Therefore, an efficient internal market, high capital mobility, and a greater flexibility of the domestic labour market should offset the limited flexibility of the international labour market.

Promoting long-term financial stability and stimulating supply in the labour market should be seen as two integral parts of one and the same process. This means a stronger emphasis on reforming the pension and health insurance schemes inherited from the past decades. (That applies equally to both the present member countries and the new ones).

The ageing of the population and subsequent low employment levels make it increasingly important that any future reforms tie the benefits offered by the pension system more closely to individual contributions. Reducing the relative importance of the solidarity principle and enhancing the importance of individual participation would make it possible to strengthen long-term financial stability and at the same time stimulate the labour market.

What are the strengths the European Union should nurture and develop to meet its economic challenges?

The European Union plays a major role in global trade. EU trade policies have a strong impact on the world economy. The regulations governing the EU's internal market pertaining to areas like competition, product quality and safety requirements are shaping similar developments in other regions of the world.

Increasing competitiveness by further improvement of the EU's internal market should certainly be one of the common priorities of all EU member countries. On-going convergence and the improved operational efficiency of the internal market should result in a more efficient use of resources, increased price flexibility, and lower transaction costs. The services sector accounts for 70% of the EU's GDP but there are still many restrictions on establishing businesses and providing cross-border services in the member states. It is extremely important that the future common market cover's all goods and services, including financial services. In addition to the common currency we should aspire towards the full integration of capital markets.

While we are bringing the Financial Services Action Plan to a successful conclusion and continuing to promote the financial markets' integration, we should, at the same time, develop closer cooperation in the field of supervision and a more systematic way of sharing information. This would help us alleviate the contagion risks of a more closely integrated market.

Besides its significant role in global trade, the EU has, for a long time, been a net investor on the global scene. At the same time, the investment rate within the EU, especially in the 'old' member countries, could have been and should be higher. Investment policy is certainly one of the key issues for the economic perspectives of the new Europe. Promoting investment would also indirectly help the EU achieve the goals of the Lisbon strategy.

Estonia's experience can be seen as a good example of the benefits to be gained by openness and investor-friendliness. The two guiding principles the Bank of Estonia has been following in developing its financial policy have remained the same for more than ten years. A currency board based monetary system and a team of highly experienced, reliable and decision-committed core owners are the principles that have brought stability and transparency but also innovative new products and technologies into the Estonian financial environment.

Strategic foreign ownership - mostly by Scandinavian financial groups - has provided Estonian banks with both strong capitalization and a transfer of the best international practices. At the present time the Estonian banking sector is responsible for a significant share of their owners profits.

Profitability means effectiveness at least comparable to the financial sectors of our neighbouring EU member countries and a somewhat greater flexibility of production factors, especially the flexibility of the labour markets. Profitability also means a relatively rapid adoption of new technologies. For example, the number of card payments per capita in Estonia is roughly equal to the respective German figures while the share of internet banking customers is somewhat higher (and the list of internet-based bank services somewhat more exhaustive) in Estonia.

Given the peculiarities of a currency board and a transition economy, it is extremely important for a country like Estonia to have a strong financial sector. It is fair to say that the Estonian banking system is presently strong, well capitalized and liquid. The banks' forced reliance on their own capital and liquidity have had a direct impact on the market structure as they have been forced to look for strong partners.

An important aspect influencing the allocation of resources is a well-balanced and sustainable fiscal policy that has a major role in supporting long-term macroeconomic stability. A strictly applied common fiscal framework supports a better allocation of private resources and long-term investments. Without a sound macroeconomic environment supporting the effective allocation of private and public sector resources, it is difficult to achieve the central goals of the Lisbon strategy.

The Stability and Growth Pact stipulations on a common well-structured approach to economic and fiscal policies are some of the most important guarantees for the Euro area development. It is assumed that automatic stabilisation mechanisms shall function smoothly within the 3% GDP scale. This threshold can be exceeded only in case of an abrupt or unexpected shock.

The Stability and Growth Pact aims at a budget balanced over an entire cycle. It is, thus, presumed that one should not look for structural reasons if a member state experiences a long-term budget deficit or surplus. In my opinion, the Stability and Growth Pact has performed its function reasonably well. This is proved by the fact that most of the EU member states now have a much stronger fiscal position than in earlier years. Any major changes in the Stability and Growth Pact would be likely to cause additional insecurity and significantly affect the credibility of the entire framework.

Estonia has maintained one of the most prudent fiscal policies among the accession countries. We have a balanced budget and the Estonian public debt remains the lowest among the accession countries and current EU members. Thus, joining the monetary union does not entail any significant change in Estonia's fiscal policy. In fact, it has been in line with the Stability and Growth Pact principles for years now. Moreover, the government sector's liquid foreign assets accumulated from privatisation receipts and recent fiscal surpluses exceed 10% of GDP (in addition to central bank reserves), double the value of gross government debt.

And last, but not least, it is of primary importance from a central banker's viewpoint that upon their accession the new EU member states are required to treat their monetary and exchange rate policy as a matter of common interest. They should pursue price stability as the primary objective of their monetary policy. Over and above this obligation the choice of monetary and exchange rate strategies still remains a responsibility of the Member States.

An Enlarged EU - Strength and Weakness A central banker's viewpoint

An Enlarged EU - Strength and Weakness
A central banker's viewpoint