HEIDO VITSUR ⟩ Why does Estonia constantly have only bad and very bad options on the table?

Heido Vitsur, economic analyst at LHV and economist. Photo: Tairo Lutter

• Estonia has lost its ambition.
• Our businesses are lacking in competitiveness.
• Potential growth has been declining for a decade and a half.

Estonian companies are lacking in the innovation necessary to increase their competitiveness, and the state has not been able to support them in this, Heido Vitsur, economic analyst at LHV Pank, writes.

Peeter Raudsepp, the head of the Estonian Institute of Economic Research, argued in an interview with Postimees on September 23 that our biggest problems in the economy are production costs that have swelled too much for goods that tend to have low value added; that our neighboring countries have action plans, but we have wasted our time. He saw greater innovation as a way out of the current impasse, and he was right.

Although there have only been two periods in the past 33 years of economic history where Estonia, generally a well-performing country, has fared worst in the world as measured by such universal yardstick as GDP growth, our ability to 'do well' has been declining for a long time, albeit quite slowly. It seems that Estonia, once so dynamic, has for some reason lost the ambition necessary for further progress while enjoying its initial success. In other words, we did not see the need to be sufficiently innovative.

These two occasions when we fared worse than others were the global financial crisis and the current economic downturn. However, compared to the financial crisis, our situation now is somewhat different. But only somewhat.

While during the financial crisis, GDP contracted and recovered relatively at the same time in many countries and entire economic regions, Estonia is now the only country on the world map whose economy is in decline for the third year already.

It seems that we are in the habit of stepping on the same rake repeatedly.

In reality, however, the difference between these two crises is not as great as our current long-term economic downturn suggests. Then too, we suffered more than others in roughly the same proportion as now. We seem to be in the habit of stepping on the same rake repeatedly.

It has to be understood that our problem is not so much the fall in GDP in these crises, but the fact that in both crises we lost more of our potential growth rate than our competitors, but we did not pay attention to this then, and we do not seem to be paying attention to it now. Why is that?

Much of the answer to this question can be found in the IMF report on Estonia published this summer (IMF Country Report No. 24/178). It concluded that although the war in Ukraine is having a negative impact on the Estonian economy, potential GDP growth in Estonia has declined steadily since the financial crisis and our current economic difficulties are at least partly due to our export capacity, which has become fragile in the past. We started to lose our exports because the competitiveness of our goods did not increase, but decreased.

It is also worth noting that although the trend in potential growth only took a downward direction during the financial crisis, the pace of potential GDP growth began to decline several years earlier. Almost at the same time as our GDP growth began to accelerate sharply after our accession to the European Union. Apparently, we could not, or did not even try, to make rational use of the money that was more readily available than before. We did not see an additional opportunity to climb higher in value chains, but preferred to spend money on making life more «beautiful».

It is also worth noting that although the trend in potential growth only took a downward direction during the financial crisis, the pace of potential GDP growth began to decline several years earlier.

And so, the IMF report concludes that, unlike Latvia and especially Lithuania, export-oriented Estonia lost market share primarily due to a decline in competitiveness and relative production efficiency, rather than a decrease in market demand. In other words, the Estonian economy was not sufficiently innovative to remain competitive. It couldn't be, if as a state, we live with a short-term horizon and in a non-complex space, where one doesn't bother to look beyond the numbers or at the relationships between numbers and things.

For example, while we point to the war as a reason for declining exports, IMF analysts argue the opposite. Their analysis showed that also when it comes to exports to the United States and the Netherlands, which fell by eight and 5.5 percent respectively, the main factor behind the decline was not the war, but competitiveness, the fact that Estonian producers had not been able to keep up with the changes that had been taking place in the market for a long time. They are right, because we lost our market share for exactly the same reason as producers of kerosene lamps lost their market share after the arrival of electric light bulbs.

The fact that many in Estonia celebrate the rapid decline of the oil shale related economy does not change the reality that our energy and chemical industries were not innovative enough. More specifically, they failed to secure the green light for a refining plant and other oil shale related projects, which could have allowed our oil shale sector to start putting more environmentally friendly and higher value added products on the market years ago.

Considering the current trend of deglobalization, which has long become inevitable, it is not hard to predict that just as we were decades late innovating in the oil shale sector, we have also lagged in exploring the opportunities offered by phosphate rock.

Unfortunately, there has been no shortage of barriers to innovation in other sectors of the economy either.

After all, the IMF analysis also showed that the decrease in exports to Sweden by a couple of percent occurred precisely because of a decrease in the competitiveness of our producers, and that exports to Finland and Latvia were also reduced, in addition to weaker demand, by a decrease in competitiveness.

We lost our market share for exactly the same reason as producers of kerosene lamps lost their market share after the arrival of electric light bulbs.

Here, too, there is nothing to be surprised about: people in the Estonian forest industry sector had long sensed that in the production of plywood, pellets, etc., the limits of further efficiency increase and increase in value added are close, that it's becoming increasingly difficult to stay in the market in the current niches, and therefore a turnaround is needed to start doing something where market conditions are better and the value added is significantly higher.

Unfortunately, it was not possible to build a pulp mill based on acquired technology or a wood chemistry company based on proprietary technology in Estonia. Thus, the innovation plans of companies in the forest sector have not yet been implemented and the prospects for higher value added, i.e. GDP and also tax revenue, are equally poorer.

Even if a methanol plant is eventually built in Pärnu with the help of various support schemes, it doesn't change the fact that by the time it starts producing, we will have lost out on many years of higher value added output from the cellulose or wood chemical industry, which does not require subsidies, and an unnecessary blow has been delivered to our own entrepreneurs' wish/assurance to invest in Estonia.

Unfortunately, nor is the development of the IT sector, which we claim to be relying on, free from political scandals and attempts to hinder progress. If this continues, we cannot expect this sector to be a growth engine either.

However, the most concise way to get an idea of the importance of innovation for our export-oriented industrial production is to look at the dynamics of our exports as a share of total world exports and compare it with that of our competitors.

Unfortunately, nor is the development of the IT sector, which we claim to be relying on, free from political scandals and attempts to hinder progress.

While in the early 2000s, Estonia and Lithuania accounted for almost the same percentage of global exports, 0.05 percent, and Latvia's exports for one-fifth less, by the beginning of last year Lithuania had managed to triple its share of global exports to 0.15 percent. While Estonia's share of global exports also grew in nominal terms to 0.075 percent, Latvia's exports reached a par with ours in the middle of the last decade. And what's worse, while our exports have declined in recent years, Latvia's exports have remained relatively stable. (Data from the IMF report.)

The IMF believes that the inability of Estonian exporters to maintain their competitiveness in target markets is a symptom of our economy's structural weakness. That investments made in Estonia are not very effective, and that we have left something undone for a long time or have not done it well enough.

It also appears from that analysis that the strong development of our IT and startup companies has not been able, and is still not able, to compensate for the weakening of the traditional manufacturing industry, which plays the greatest role in world trade.

They are right. Already in 2006, researchers from the Economic and Social Research Institute of Ireland, Best and Bradley, found in their analysis of the structure and competitiveness of Estonian business, compiled for the Estonian Ministry of Finance, that no high-quality investments had been made in Estonia. In their opinion, the weakness of Estonia's economic policy is the inability to see the challenges that Estonian businesses are facing, but also that we don't have an institutional framework capable of understanding and responding to these challenges.

Investments made in Estonia are not very effective, and we have left something undone for a long time or have not done it well enough.

They also pointed out that leaving decisions to the market usually leads to poorly coordinated and mutually counterproductive measures, so it was no surprise that of the massive foreign investments made in Estonia, only 13.2 percent went to manufacturing.

Yet they considered our situation hopeful, as they found that the small size of Estonia's manufacturing industry should make it much easier to develop a forward-looking industrial policy. Since at that time, 180 industrial enterprises accounted for more than 60 percent of Estonia's industrial output, an industrial policy that would have helped the most enterprising of these companies grow significantly faster and increase their competitiveness would have been a strong contribution to the overall social and economic development of the country – around enterprising, competitive, and therefore more stable companies a cluster of smaller companies interacting with them can form, making the Estonian economy, which has had a very low level of complexity to date, more complex. And that's where we should have started.

In fact, what they offered was nothing but what all developed countries were doing then as well, but which was not talked about at the time. But time has changed, an active industrial policy has become a reference, and in the current deglobalizing and unstable world, complexity itself has already become a value.

It follows from the above that Estonian business has not been innovative enough to remain competitive, first and foremost just because our institutions have not perceived or taken into account the general development taking place in the world and updated our business environment in the necessary way.

Innovation in technology, production and the organization of production alone is not enough for success. It requires that the institutional framework that shapes the conditions for business is itself innovative and conducive to innovation. This does not mean that institutions should intervene in business, but rather that they don't prevent businesses from being innovative.

Specifically because our institutions have not been innovative enough to provide the necessary conditions for businesses to keep pace with development, we so often find ourselves with only bad or very bad options on the table.

If we cannot keep up with development ourselves, then development will drag us along, and that's not very pleasant.