Foreign Trade Patterns between Estonia and the EU

Article excerpt

Abstract In this paper, we focus on the development of the foreign trade flows between Estonia and the EU. We observe rapid reorientation of the trade flows from the former Soviet Union towards Western markets because of economic reforms and foreign trade liberalization. Moreover, we determine the commodity groups with a comparative advantage in the EU market and analyze its dynamics. Further analysis of the intra-industry trade (ITT) shows that vertical IIT plays a dominant role in Estonian-EU IIT flows. Shares of total, vertical, and horizontal IIT have grown rapidly since 2004, the year of accession to the EU.

Keywords Estonia * Comparative advantage * Vertical/horizontal intra-industry trade

JEL F15 * 057

Introduction

After re-establishing independence in 1991, Estonia began to implement structural economic reforms. The keyword of those reforms was reorientation- from the former Soviet market to Western markets and, especially, the EU market. This reorientation led to the liberalization of the economy and trade. The development of the foreign trade since the liberalization was more rapid than GDP growth, especially in the beginning of the transition process.

For the extremely open Estonian economy, foreign trade is the main engine of the economic growth. The Estonian foreign trade balance has been in deficit since 1994, and the deficit has grown more than 11 times. The main reason for this growth in deficit is the rapid growth of importing which was generated by a strong domestic demand for investment and consumption goods. Understanding the main factors behind the structural development of Estonian trade is an important condition for effective macroeconomic and industrial policy.

In this paper, we focus on the development of foreign trade flows between Estonia and the EU. The objectives are to analyze the nature and aspects of structural changes that occurred in trade flows from the beginning of the 1990s up to 2007 and to determine the factors behind these changes, including comparative advantage and intra-industry trade. We base our work on the statistical and econometric analysis of the data available on trade flows.

First, we analyze the dynamics of trade flows between Estonia and the EU. The next sections are devoted to Estonian comparative advantage and intra-industry trade. Both sections present theoretical framework as well as the empirical analysis. Conclusions follow in the final section of the paper.

Dynamics of Trade Flows Between Estonia and the EU

The Estonian economy is characterized by a high level of openness. The important factors in Estonian economic openness are its advantageous geographical location and remarkably liberal trade regime. In the early 1990s, the ratification of bilateral free trade agreements formed the legislative basis for the development of trade with both EU members and, at that time, the potential members. Estonia signed The European Agreement (Association Agreement) in June of 1995 which came into force in February 1998. The economic sense of the agreement was to abolish all trade barriers (if there were any) to industrial products and to create a formal free trade area between Estonia and the EU. The transition period for the agreement was not implemented because Estonia already operated with a liberal trade policy and had very marginal import taxes. The agreement ended up having more of a political and institutional influence. Estonia has been a member of the WTO since 1999 and a member of the EU since 2004--in both roles helping to implement common foreign trade policies.

In the beginning of the 1990s, rapid reorientation of the Estonian foreign trade from the markets of the Commonwealth of Independent States (CIS) to Western markets took place. Among the reasons for the trade reorientation in the beginning of the transition were the high inflation in Russia, the collapse of the system of payments, the introduction of import tariffs in Russia, the rise in prices of raw materials, and an unstable overall economic climate. …