Favourable geographic location in the neighbourhood of Nordic countries, radical reforms of the early 1990s, relatively low production costs and attractive tax system have created solid grounds for the economic development witnessed in Estonia over the last 10 years. Deterioration of trade balance, acute shortage of labour and excessive increase in wages that outperforms the increase in productivity all indicate, however, that the hitherto competitive advantages of Estonia will soon be exhausted.

This book draws together a number of papers that analyse the opportunities that entrepreneurs and public policy have to enhance Estonia’s competitive advantages and advance the development of less prosperous regions of the country.

The first part of the book outlines the effects the on-going economic integration in the Baltic Sea Region has on Estonia’s economic development. The second part analyses the market situation and development strategies in a number of Estonia’s key industries (clusters). The final part of the book discusses the options for public policy to improve regional cohesion in Estonia.

Table of Contents


1. Regional economic integration in the Baltic Sea region
1.1. Productivity and the growing standard of living
1.2. Specialising of Estonia in international division of labour
1.3. Annex

2. Directions of development of major economics clusters of Estonia
2.1. Cluster analysis of economics of Estonia
2.2. Wood processing
2.3. Metal working and machine building
2.4. Textile and garment industry
2.5. Food products industry
2.6. Electronics industry
2.7. Plastics processing
2.8. Tourism and recreational economy
2.9. Transport and logistics
2.10. Annex

3. Regional dimensioin of Estonian economic policy
3.1. Role of the state in economy
3.2. Difference in real incomes between regions of Estonia and causes of formation
3.3. Regional structure of development investments of Estonia
3.4. Efficiency of public policy
3.5. Annex

4. Conclusions and policy recommendations
4.1. Specialisation of Estonia in economic clusters of the Baltic Sea region
4.2. Conclusions to policy of economic development of Estonia

Executive Summary

In a small open economy, increase in the standard of living is primarily dependent upon the capability of entrepreneurs to gradually shift their position in the international division of labour towards new, higher value-added fields of activity while ceasing operations in less productive fields. Under the conditions of free movement of capital, goods, services as well as labour, Europe’s national borders are important for entrepreneurs only to the extent that the economic environment (incl. public policy) of a specific country offer relatively more favourable circumstances for one or another type of business activity.

This means that countries compete within Europe – just like entrepnreneurs on the market – in their capacity to offer attractive physical and social environment where smart, economically active people would like to live. In practical terms, this entails, above all, a free and open business environment that does not reject anyone for reasons beyond their control and gives a chance to everyone serious about trying. It also entails roughly balanced regional and social development and well-functioning public services that assist entrepreneurs in their efforts to beat international competition with progressively novel and better goods and services. All of the above combined with respective implications for education, research, technology, labour and other policies is what constitutes the essence of contemporary economic development policy.

Close ties with the Nordic countries helped Estonia overcome the transitional economic crisis of the early 1990s much faster compared to its neighbours. Albeit economic integration has been deepening steadily throughout the consequent years, economic relations between the Nordic and the Baltic countries are still vastly asymmetric. While the Nordic countries are specialising on relatively more knowledge and technology intensive fields of activity, Estonia and other Baltic countries have picked up various resource and labour intensive fields, incl. the parts of certain medium and high technology fields (e.g. electronics assembly and the like) that are intensive in manual labour. While the Nordic countries are brokering investments from global financial markets to the Baltic Sea region and coordinating economic activity in various cross-border business clusters, Estonia and other Baltic countries have engaged in the relatively less value-added activities.

In the past few years, Estonian enterprises have reported strong business results in most sectors. Mostly driven by private sector foreign debt and rapid growth in domestic consumption, current economic boom has created a sense of welfare in Estonia, but has also incresed risks. A current account deficit constantly in excess of 10% has made Estonian economy very vulnerable to external shocks. Acute shortage of labour in virtually all professional categories and an average annual wage growth of 10-15% have forced entrepreneurs in nearly all sectors to drastically reconsider their business strategies. So far, one of the primary competitive advantages of Estonian economy has been the proximity of a wealthy market with high purchasing power and relatively lower production costs compared to the Nordic countries. Then again, taking into consideration the low level of productivity in Estonian manufacturing industries, Estonian labour is not really all that cheap – on the contrary, it is actually more expensive in comparison with Finland, for instance, which has a much higher standard of living. Estonian enterprises may have very hard-working employees, but due to the nature of their work, the level of value they add to each product is simply too low.

Interviews conducted with the managing directors of about 150 largest Estonian enterprises for Estonian regional innovation strategy project reveal that companies with foreign ownership have fairly solid prospects. The future of those domestically-owned enterprises that deal with small, single orders, on the other hand, is relatively uncertain. Since the output of these enterprises is often more expensive than that of their competitors in Southeast Asia and their costs are on the rise, these enterprises can no longer rely on the cost advantage. Lack of further specialisation (e.g. wood and metals manufacturing industries), high capital-intensity of the sector (e.g. machinery and electronics manufacturing industries), low market power of the enterprises (e.g. food products and clothing manufacturing industries) or a combination of the above factors, however, make it impossible for them to either acquire the specialised equipment they need to increase productivity or to build their brands into major market players outside Estonia. This problem is particularly hard on relatively smaller, domestically-owned enterprises.

Although enrepreneurs regard labour shortage and rapid increase in (labour) costs as a major challenge to the growth of their enterprises, so far they have made no radical changes to their business strategies. Enterprises in most sectors respond to the rapidly growing demand from domestic and neighbouring markets by increasing their production volume without simultaneous changes in the level of technology the enterprise uses or in their market orientation.

Regional disparities in the standard of living within Estonia essentially reflect variations in economic specialisation and differences in employment, quite the same way as the comparison between Estonia and its neighbouring countries does. Even as the unemployment indicators are at their 10-year low due to rapid economic growth in recent years, many counties located far from major centers still face very high levels of unemployment and struggle with economic restructuring.

Public policy analysis reveals, however, that the government has just about as little of an understanding as entrepreneurs do about how much labour and of what qualification will Estonia need in, say, 5 or 10 years. By 2010, at the latest, both vocational and higher education institutions are facing the roughly halving of the number of students expected to continue their education after high school, yet neither systems have a clear plan for reform. Planning of the public sector mechanisms to support entrepreneurship has also been fairly hectic: specific aims and target groups of the support mechanisms are either inadequately defined or have changed rapidly across different years. It is therefore of no surprise that the impact of most of these mechanisms on Estonia’s standard of living is rather modest.

Various macroeconomic forecasts appear quite unanimous about the assessment that Estonia’s current economic cycle is quickly coming to an end, and that a decrease in foreign debt financing and in domestic consumption will intensify pressures for the restructuring of Estonian economy. Lack of a vision in the manufacturing industries will make this rather complicated, seeing as the slowing economic growth will significantly reduce the opportunities of entrepreneurs and of the government to make long-term investments for future purposes

4. Conclusions and policy recommendations

Formation of public policy is similar to fashion industry, in one very important aspect: in both, for achievement of a success, it is crucial to recognize and use the right concepts and keywords of the season in progress, while taking diligent care that with the alteration of seasons the strategic core of the pursuit would not be lost from sight.

Differentiation of short-term phenomena from longer-term perspective of economic development needs not be always simple; however it is indispensable both to entrepreneurs and the state for formation of competent development strategy. The Estonian economy has in recent years grown very rapidly, fuelled by influx of capital and domestic consumption. Nothing nevertheless guarantees spontaneous continuation of such a growth. Rather the contrary!

The growth of welfare of a small country does not base on the feeling of convenience, taken on loan from the tomorrow and the blooming domestic trade, but on venturesome entrepreneurial people and a developed industry, wide range commodity exchange, promoting sale of goods in external markets and an efficient government, letting all that happen.  Whereas David Ricardo acknowledged in the 19th century, when putting down in his theory of comparative advantage in a fact actually quite easily understandable in common logic: in a longer perspective in free market, those entrepreneurs turn out more successful who combine most effectively their business with both the moves of other market participants and the public policy. This means that even if policy makers should genuinely hope that they could offer to all entrepreneurs the policy befitting all uniformly well, they would still de facto create advantages to some entrepreneurs, with respect to others.

4.1. Specialisation of Estonia in economic clusters of the Baltic Sea region

Estonian economy is very closely integrated into economy of the Baltic Sea region and it participates this way in global economic competition both with other European and the North American economic areas, such as for example Perl River Delta region of approximately 100 million people in China or similar ones elsewhere. Whereas the economic growth of Asia with its continuingly relatively cheap production inputs is making it one of the most preferred area for development of low cost mass production. One of the most important strategic advantages of the Baltic Sea region in global competition however derives from the opportunity to combine, in geographically adjacent countries, the advantages arising from knowledge and technology intensive production in the Nordic countries with comparatively lower cost of production inputs in the Baltic States and Poland.

Strong cross-border economic clusters have historically evolved in the Baltic Sea region. The dynamics of these clusters is predominantly set by larger enterprises of the Nordic countries. The main role of the Baltic States in the global supply chain has, however, become that of production of small scale and at the same time not overly complicated consignments presupposing quick delivery, and supply of local raw materials. At that the Estonian production inputs are rapidly appreciating and the cost competition is stepping up, in a number of areas. One of the main issues facing the Estonian economic policy is therefore, how the enterprises can keep pace with changes occurring in markets and shift in international production networks to higher value added roles, i.e. move from primary processing of raw materials closer to end consumers.

For stronger, mainly foreign owned companies Estonia suits for business development rather well. Transfer of production from the Nordic countries to Estonia allows such a company to retain the majority of its hitherto competition advantages, while strengthening the cost advantages. The increase of salaries in Estonia and the appreciation of other production inputs is not going to be in near future a problem to such companies. These companies of larger market power, who typically co-ordinate in low and middle technology sectors the production activies, would be ready to procure from Estonia more production inputs, including the components of certain larger products, maintenance of equipment etc. The problem here however lies in the weakness of local suppliers and service providers.

Several smaller enterprises, which have acted until now mainly in Estonian market or have produced to nearby markets in specific limited run job lots a relatively wide range of different products, are getting due to rapid growth of expenses in a rather complicated situation. The equipment used in such, mostly indigenous, companies is not quite suitable to any specific product, whereas the inability to specialise more narrowly and to increase decisively the production volumes does not allow for substantial increase of the productivity either.

Yet, rapidly growing costs force the enterprises to increase their productivity by strengthening their competences in production management, technology and design. Therefore it is not surprising that the entrepreneurs expect from the government more active steps in increasing the quality of education and in providing more support to technological development.

4.2. Conclusions to policy of economic development of Estonia

As structure of industry, competitive advantages and market dynamics are rather different in various branches of economy, so are the specific needs of enterprises for development. The impact of universal policy measures designed to meet the needs of every enterprise will therefore, inevitably turn out unforeseeable and limited. This is why Estonia needs a strong cluster based economic policy, which would take in practical policy formation into account the diverse dynamics of various industries and thence their different needs for development.

Dominant clusters in Estonia and in the Baltic Sea region can rather well be described through daily practical co-operation of entrepreneurs, their clients and suppliers and various servicing sectors. For the majority of Estonian exporting companies the primary market is major companies in neighbouring countries, for whom they produce components of certain end products etc. Further development of competitive edge of Estonian industry depends, thus, in the first place on strengthening the supply of qualified labour and engineering services of the domestic subcontractors, which will enable them to move step-by-step from provision of manufacturing services to own design manufacturing etc. Such a dynamics will allow simultaneously bind the local affiliates of foreign investment enterprises with Estonia and will boost their positive effect on economic development of Estonia.

Setting the priorities of education, research and technology policies is not a trivial task, and simple extrapolation of the hitherto trends of Estonia is not a best device for describing the future labour needs of the companies. Strengthening of the education system presupposes a more active strategic dialogue between the associations of entrepreneurs and the government, as well as a significantly systematic analysis of the dynamics of global economy. The future roadmaps, composed in sufficient detail for 5-10 years by industry associations, each for their domain, both on Estonian and the European levels could therefore play a critically important role in deciding on future priorities of education and research and technology policies.

In several middle and low technology sectors the smaller companies experience in acquisition of new equipment major difficulties already today. Eventually, with the decline of demand of domestic market the situation will become for such enterprises quite complicated. In certain cases, the public intervention may become necessary in one form or another. Unless the problem-ridden enterprises will be restructured, public sector support for renewal of the equipment stock may, however, easily amount to subsidizing unfeasible and in the longer perspective unsustainable businesses. Therefore, the state should rather seek for opportunities for joint operations with investment banks or funds, who would conjointly assume a significant role in rethinking the strategies of the respective companies. The state would support on its part, as needed, the restructuring of such companies by offering continuous education or retraining of labour etc.

Thence the need for much stronger co-ordination of education, entrepreneurship, regional development and labour market policies. Creation of new workplaces in regions of high unemployment is not to be solved by solely providing a start-up aid to beginning entrepreneurs. Putting every such region “on move” presupposes a larger (foreign) investment of some type into a certain pivotal enterprise or infra¬structure, which would create a new market for smaller local suppliers. Given the extremely limited administrative and financial capability of Estonian municipalities, any major change(s) will remain in this respect subject to the initiative of the central government.

The economic policy of the independent Estonia has focused during the past 10-15 years on promotion of free trade. That is in every way a suitable policy for a small country, however it is not enough. To allow for the further increase of the living standard, Estonia is to become a truly industrialised economy.