Chapter 2
PRICE AND TRADE POLICIES

I. Introduction: Recent Economic Trends in the Sector

Chapter 1 commented on the fact that the transition to new economic system has created severe difficulties for agriculture thus far. In the interest of developing the most comprehensive picture possible, in the following paragraphs the trends of recent years are documented from various viewpoints: production, income, prices, food consumption and foreign trade.

A. Agricultural Production and Income

The decline of agricultural production, and of income for producers, began for some products in the latter part of the 1980s and then became more generalised in the early 1990s. Production of potatoes, for example, fell abruptly in 1987, recovered slightly in 1989, and then declined further. Grain output declined precipitously in 1988, then recovered, and fell sharply again after 1991: Fruit production has declined almost continuously since 1986, as has beef production.

Individual products, of course, respond to particular factors, so the clearest picture of sectoral production trends is provided by the aggregate series on gross agricultural output (Table 2-1). In addition, it is important to take a relatively long-run view, since weather and market fluctuations can strongly influence production in the short run. From Figure 2-1, it can be seen that in 1995 total output in the sector stood at 53% of its 1986 level, and 63% of its 1991 level. Hence most decline has occurred after 1991. Drought conditions affected harvests in 1992, but the continuing downward trend subsequent to that year makes it clear that other, more fundamental factors have been affecting production levels.

Figure 2-1.
Gross Agricultural Output, 1987 – 1995
(1986 = 100)

Source: Ministry of Agriculture.

Trends in real producer income, or income adjusted for inflation, have paralleled those of production. In the official statistics, the concept of real producer income is measured by real agricultural GDP (value added) in the national accounts, and its data series show a decline of 24% between 1992 and 1995, with no gains in any of those years. (See Statistical Office of Estonia, Estonian Statistics, 1996, Monthly no. 5 (53), Tallinn, 1996, p. 34.) This is a sector-wide average, and some farmers fared better and others worse, but it is evident that the economic situation of most of them deteriorated substantially.

B. Agricultural Prices

The relevant aspect of agricultural prices is how they have moved in relative terms, that is, in relation to production costs, in relation to other prices in the economy in general, and in relation, to international market prices for the same commodities. Agricultural prices expressed in relation to all prices in the economy are referred to as real agricultural prices. They measure the purchasing power of agricultural production, in terms of all goods and services in the economy. Although a!i prices rise in an inflationary period, if agricultural prices rise by less than other prices, then agriculture's purchasing power declines, and real agricultural prices are said to fall.

The analysis here is carried out for the period beginning in 1992, since that was the year in which the present macroeconomic policy framework was established. In addition, it is difficult to compare pre-1992 rouble prices with the subsequent prices in kroons. Nevertheless, it should be noted that all observers agree there was a very large decline in real agricultural prices in 1991.

To analyze prices for the agricultural sector as a whole, it is necessary to construct an index of agricultural prices, or a weighted average of movements in prices of individual crops and livestock products. (The weights in such a case utilise the production levels of the products.) Such an index has been constructed on the basis of the ten principal products in the sector¹ (see appendix 2A). When it is defined relative to the consumer price index, which is a measure of the level of most prices in the economy, the real agricultural price index shows a decline of 40% in the three years from 1992 to 1995.

¹ Beef, pork, poultry, eggs, milk, potatoes, rye, wheat, barley and oats.

Another way of comparing agricultural to non-agricultural prices is to contrast the movements in the implicit deflators of gross domestic product (GDP) for agriculture and for the non-agricultural sectors in the economy. These numbers are a kind of average price for each of the respective sectors, and they are used to “deflate” (divide) nominal GDP (or value added) in a sector in order to obtain a measure of real GDP. According to the official national accounts statistics, the GDP deflator in agriculture fell by 30% relative to the GDP deflator for all non-agricultural sectors, between 1992 and 1995.² (The decline occurred each year in that period, including 1995.)

² This measure is sometimes referred to by economists as the “intersectoral terms of trade for agriculture.”

These results are different statistical measures of the purchasing power of farmers' incomes, and they show unambiguously that there has been a large decline in that purchasing power in recent years. Another way to measure relative price movements is to compare the rates of increase of consumer prices for food and non-food products. That concept was also reviewed for this Strategy, and it was found that food prices increased substantially less rapidly than non-food prices over the period 1993 to 1995 (the breakdown of the consumer price index was not available for 1992). Specifically, from the average for the year 1993 to the month of May, 1995, the ratio of food to non-food prices in the consumer price index fell by 29%. In other words, nonfood prices increased almost one-third more rapidly than food prices to the consumer over that period.

All these analyses point in the same direction, that there has been a significant erosion of farmers' purchasing power since 1992, even after its abrupt decline in 1991. A later section of this Chapter discusses why this trend in relative prices has occurred under the new economic policy initiated in 1992.

Ironically, while Estonian farmgate prices have been deteriorating from the viewpoint of farmers, they have been increasing from the viewpoint of external markets, thus eroding the competitiveness of Estonian exports and making imported food products more attractive to Estonian consumers. -This has occurred because Estonia's exchange rate is fixed for our major export markets although domestic prices have risen substantially since the new exchange rate policy was adopted in June of 1992. Thus Estonian agricultural products expressed in Deutsch marks and many other foreign currencies have become steadily more expensive.

We are in the paradoxical situation that while our farm prices are “too low” to sustain much of our farming, they are “too high” in world markets!

C. Foreign Trade

Food products traditionally have figured among Estonia's principal exports, and the net foreign trade balance in food had always been strongly positive. However, in recent years this situation has changed dramatically, and the agricultural trade balance has turned negative (Figure 2-2). While the kroon value of food exports-grew rapidly from 1992 to 1994, part of that growth was explained by domestic inflation of product prices, and food imports grew more rapidly than exports. In 1995, the value of food exports actually declined, in spite of prices increases in that year, and the first half performance in 1996 did not suggest much of a recovery, if any. Nevertheless, in 1996 food imports continued their rapid ascent.

Table 2-2.
The Structure of Foreign Trade, 1992 – 1996
(million kroons)

Source: Statistical Office of Estonia.

The balance of trade for the entire economy also turned sharply negative in 1994, and the deficit continued to widen in subsequent years. An inflow of direct foreign investment has been one of the principal factors in sustaining the growing deficit in the balance of payments, but that inflow declined 1996, for the first time since the new economic policy was instituted. Therefore the sustainability of the balance of payments is not only a question for agriculture, but for macroeconomic policy as well. ,

Table 2-3 provides a breakdown of the international trade figures for agriculture, by major product group.

Table 2-3
Breakdown of Food Exports and Imports
(million kroons)

Source: Statistical Office of Estonia.

D. The Conditions of International Trade

In regard to possible external economic developments, the Estonian Government already has made its major choices with respect to international trading arrangements, in the form of decisions to apply to join both the WTO and the European Union. The latter will take a much longer period of time to be consummated, but a preliminary EU recommendation for approval already has been made, and in the interim the Association Agreement will represent a binding commitment for Estonia.

Both decisions on trade policy promise to give Estonia greater access to external markets. For example, the Association Agreement will increase EU import quotas for Estonian products ten percent per year and reduce the tariffs applicable on those sales by cumulative amounts of 20 percent, 40 percent and 60 percent, respectively, in the first three years of the agreement.

Although accession to EU, which is a protectionist bloc, would appear to run counter to the liberal economic principles of Estonia, it can be pointed out that:

1. The degree of price and tariff protection in the EU, vis-a-vis the rest of the world, has declined over the past ten years and can be expected to continue to decline.

2. Estonia's accession would imply increasing access to the European market, as noted above, and this access should offset any disadvantages created elsewhere.³

3. EU membership can be expected to bring political benefit which cannot be represented in strictly economic calculus.

³ However, in order to benefit from this access, considerable effort is required to educate famers and exporters in regard to the quality requirements of the European market.

The agreements with the WTO and the EU effectively obviate concerns which have been expressed about other scenarios, such as being limited by the capacity of the Finnish market. Accession to the EU will also facilitate exports to Russia, which already have found various channels through which to proceed. The main economic constraint there may be the price in the Russian market. As regards the other Baltic States, a free trade agreement already has been signed, although implementation apparently will be slow. Hence in an operational economic sense, there do not appear to be major new options with respect to Estonia's immediate neighbors on the north, east and south.

There are, however, real uncertainties as to the agricultural policies and prices that will be applicable if and when Estonia becomes a member of the EU. It is well known that there are pressures within Europe to reduce the level of CAP support, pressures that will be exacerbated by the admission of Central and Eastern European Countries, especially ones like Poland that have large agricultural sectors. It seems quite unlikely that the gap between European and world market agricultural prices will be as high as it is today, when Estonia becomes a member. In fact, there is increasing interest in Europe in the option of moving entirely away from support which is linked to prices and to support which takes the form of direct income supplements to farmers.⁴Additionally, in such a case, the fiscal burden of direct support would have to be borne by the respective member countries. If price-linked support were maintained, it is possible that the benefits of membership could be eroded by compulsory set-asides and other forms of production controls.⁵ Therefore, considering all major possibilities regarding future trends, it appears that. ironically, Estonian exporters of farm products may gain more in price during the period governed by the Accession Agreement than when full membership is attained.

⁴ See, for example, Martin Strittmatter, “The European Union and Central Europe,” in Trade Liberalisation and Its Impact on Farm Economy,” The Fifth Finnish-Baltic Seminar of Agricultural Economists. Maatalouden Taloudellinen Tutkimuslaitos (Agricultural Economics Research Institute),'Research Reports No. 203, Helsinki, Finland, 1995. See also S. Tarditi, J. Marsh and S. Senior-Nello, “Agricultural Strategics for the Enlargement of the European Union to Central and Eastern European Countries,” study prepared under the Phare Programme for the Directorate-General I of the European Commission, January, 1995.

⁵ Tomás Garcia Azcárate, “The Evolution of the CAP in the European Union: Some Personal Reflections,” in Trade Liberalisation and Its Impact on Farm Economy, op. cit.

While international trade agreements have been reducing the agricultural subsidies which affect prices in international markets, there still is a significant amount of price distortion from this source, especially for dairy products, wheat and beef, and to a lesser extent for coarse grains and other products. Table 2-4 contains estimates of the percentage change in world market prices for food products that would result from: a) elimination of agricultural subsidies in all countries, and b) elimination of subsidies in all sectors in all countries. It can be seen that prices for dairy products would be expected to rise from 40% to 50%, approximately, a shift that obviously would benefit Estonia very greatly. We would benefit also, albeit to a lesser extent, from the price changes for beef and grains. Hence the continuing movement toward reduction of price interventions in trading countries can be considered a very beneficial trend for Estonia.

As regards the possibility of Estonia exploiting new markets, e.g., East Asia or the Middle East, it must be borne in mind that such markets are not likely to offer a price which differs significantly from the prevailing international price, and there are competing suppliers for all markets.

Taking advantage of the improved access to European markets will require significant modifications in our food processing industry, in order to satisfy the quality standards of the EU. The investment requirements will be very substantial, and in some cases the sector's ability to finance them may be in doubt. (This issue is discussed in Chapter 4 of this Strategy.)

The quality standards are not as demanding for some other export markets, particularly those of our eastern neighbors. In all markets, prices are important and they generally follow international trends. World prices are important even when the traded quantities are small, because usually the price in all segments of a market is set by the segment which accepts the lowest price. Future price trends on international markets will vary by commodity. International price projections are subject to frequent revision, and therefore are not very reliable, but recent international consensus foresees declines in grain prices and increases in beef prices, in real terms. Table 2-5 presents price forecasts for a number of important agricultural commodities.

Table 2-4
Estimated Changes in International Prices Resulting from Elimination of Subsidies in All Countries
(%)

Source: Goldin, I., O. Knudsen, and D. van der Mensbrugghe, Trade Liberalisation: Global Economic Implications, OECD, Paris, 1993. Cited in Tarditi, 1997.

Table 2-5.
Commodity Prices: Recent Trends and Projections
(in constant 1990 dollars)

Source: World Bank; skim milk, FAO.

II. Past and Current Policies

The Effects of Policies on Farmers' Prices

The very great change of economic policy regime that Estonia has experienced in recent years completely altered the policy framework for agriculture. Under the Soviet system, Estonia's farmgate prices were supported at levels that were quite high relative to other prices in the economy. Input prices were kept low, and markets for Estonian beef and dairy products were guaranteed in St. Petersburg and other regions of the Soviet Union. The artificial pricing regime of that time proved unsustainable, and as a by-product of the changeover to a market system. Estonia's farmgate prices fell precipitously relative to non-agricultural prices, especially from. 1990 to 1992.

The new policy framework has been characterised by an almost completely open foreign trade regime and a virtual absence of internal support measures for farmers. As a consequence, the net implicit and explicit subsidy extended to Estonian agriculture fell from one of the world's highest to the lowest. Table 2-6 shows those net subsidies, or net policy-induced transfers to producers, as a percentage of producer prices (producer subsidy equivalents, or PSEs). It can be seen that since 1992 Estonia's PSEs have been lower than those of any OECD country. so low-that they are in fact negative. These transfers include those which are brought about by market interventions, and therefore are paid by consumers, as well as those which are given directly from the Treasury, and therefore are paid by taxpayers. The reference points for the calculations of the PSEs are international prices. In other words, they measure the extent to which policy interventions have permitted the domestic farmgate price to be above (+) or below (-) its international equivalent, adjusting for handling and trade margins.

Table 2-6.
Producer Subsidy Equivalents (%) in OECD Countries

Source: OECD.

A commodity-specific analysis of the net policy support to agriculture in the area of prices is provided by estimates of nominal protection rates in Estonian Agriculture. Nominal protection rates are ratios of domestic to international prices, again making adjustments for handling and marketing margins so that equivalent concepts of prices are being compared. A nominal protection coefficient (NPC) of less than one means that domestic production is receiving negative protection; e.g., an NPC of 0.80 would indicate, that domestic prices are 80 % of their international equivalents. Conversely, a value of more than one indicates that policy is providing positive protection. An NPC of 1.15 would show that domestic prices have been allowed to rise to 15 % above their international equivalents.

The policy instruments that provide nominal protection usually are tariffs, but controls on imports can also allow the domestic price to rise above its international equivalent. Direct price controls could have the same effect. Negative nominal protection may indicate inefficiencies in the domestic marketing chain which prevent the domestic price from rising to the level of the price of competing imported products.

The Effects of Policies on 'Producers' Incomes

A related concept is the effective protection coefficient (EPC). It measures the net support given to producer incomes by the various policy interventions and structural bottlenecks that affect prices. In effect, it sums up all the policies that have a bearing on agriculture in terms of their consequences for producers' incomes. However, unlike the case of the NPC, the EPC is affected in two different ways by tariffs. To take the case of livestock products as an example, tariffs on the imports of those products raise producers' incomes and therefore raise the EPC, but tariffs on. grains, which are inputs into livestock production, lower the incomes of livestock farmers, and therefore they reduce the EPC. Similarly, tariffs on industrial goods in general raise the costs for agriculture and therefore reduce agricultural incomes, a fact which is reflected in a reduced value of the EPC. Thus tariffs are two-edged swords. The EPCs measure these two-way effects and the effects of all other price interventions in the economy which have consequences for farmers' incomes.

Table 2-7 shows estimates of both nominal and effective protection rates, and the average profitability of production, by principal commodity in 1994 and 1995.⁶ The nominal protection rates have been been calculated twice in some cases: with respect to the price of competing imported products, and with respect to the price that Estonian products would receive as exports. Because of international transportation costs and port handling charges, usually there are significant differences between an import price and an export price for the same commodity.

⁶ S. Yao, Comparative Advantage of Agriculture, Forestry and Fishery under Economic Transition in Estonia, report prepared for the Government of Estonia and the FAO, May, 1997.

Table 2-7.
Nominal and Effective Protection and Profitability in Agriculture

Notes to Table 2-7.

Profits are measured in kroons/ha. for cereals and potatoes and wood products, kroons/ton for livestock products, and thousand kroons per boat for fishing. For the latter, the first figure refers to old boats and the second figure, to modern boats. See text for definitions of the other coefficients.

From Table 2-7, it can be seen that in 1994 and 1995 grains and potatoes were receiving negative protection, in both the nominal and effective senses. Beef also received negative protection vis-a-vis imports, but as an export product it received positive protection in 1994 and negative protection in 1995. This latter result is no doubt a reflection of year-to-year variations in international prices, which tend to fluctuate more than domestic prices for many commodities. Milk experienced negative protection as compared to the price of imports but positive protection as an export. However, the high rates of international subsidy on beef and milk (Table 2-5), which depress international prices for those commodities, must be borne in mind in evaluating these results. Pork and poultry were the most protected of Estonian farm products in those years.

Fisheries protection also was negative on average, as was protection for logs and pulpwood. Sawnwood and plywood, however, received some positive protection.

On the profit side, in 1995 all agricultural commodities except potatoes lost money for the producers. In 1994, most commodities were in that situation. These facts are well known from discussions with producers, but it is useful to have them confirmed quantitatively, for the sector as a whole, by these analyses. Fishing and forestry continued to be profitable in 1994 and 1995, but in the case of fishing it must be recognised that the level of profits does not permit replacement of aging vessels and equipment (see Chapter 9 of this Strategy).

Intersectoral Aspects of Macroeconomic Policy

Since 1992 economic policy has placed great emphasis on stimulating productivity improvements in the primary and secondary sectors (agriculture, mining and manufacturing), by obliging producers in those sectors to face a situation of reduced profitability. As discussed in a later section of this Chapter, the maintenance of a fixed nominal exchange rate (with respect to the Deutsch mark), in the face of continuing domestic inflation and in combination with a completely open trade policy, has been the principal instrument of this policy. It has meant that the trade-oriented sectors are experiencing a cost-price squeeze which becomes tighter by the year. This phenomenon has been remarked on by outside observers as well; see, for example, the OECD's Review of Agricultural Policies: Estonia, 1996, para. 147.

At the same time, real prices and profits have improved for the service sectors, and as a result Estonia's economy has been shifting in the direction of becoming a supplier of services more than a producer of goods.

This structural shift can be seen in the following official statistics concerning the change in real GDP by sector from 1992 to 1995:

These figures indicate a very large structural change. For example, financial intermediation (banking) expanded almost 60 % relative to agriculture, and more than 60 % relative to manufacturing. The growing sectors are those which are not exposed to, or dependent on, international trade. The shrinking sectors are those that are engaged in trade and/or face competition from imports.

The structural change has been so great that even public administration increased relative to agriculture, mining and manufacturing, in spite of the commitment to reduce the size of the government. The increase in real value added in the public administration sector that is recorded in the national accounts is reflected also in the expenditure side of those accounts, which shows that government consumption (valitsemissektori lõpptarbimiskulutused) increased more rapidly than private consumption (eratarbimiskulutused) over the 1992 – 1995 period. In current prices, those increases corresponded to annual rates of growth of 67.0% and 48.6%, respectively.

With the exception of energy, gas and water, the shrinking sectors are those which experienced a decline in their intersectoral terms of trade (real prices), as measured by their implicit GDP deflators.⁷ This again shows the effects of the cost-price squeeze on the economy's productive sectors.

⁷ In the case of energy, gas and water, rate adjustments accounted for the price increases, while lack of sufficient investment funds for the sector, plus the general decline in the economy, undoubtedly accounted for this sector's decline in real value added.

It should be borne in mind that these sectoral trends mean there has been a very substantial intersectoral transfer of incomes in Estonia, away from the primary and secondary producing sectors and into the tertiary (service sectors).

The cost-price squeeze on agriculture, and the associated intersectoral transfer of incomes, has had many implications for the sector, including a high rate of bankruptcies of farms and farm enterprises, increased rural poverty and social problems (Chapter 8), inability to make investments in modernisation of equipment (Chapters 3 and 4), and the abandonment of cultivation in extensive amounts of land (Chapter 3). To place matters in a proper perspective, not all the sector's problems can be blamed on the decline in real agricultural prices and profitability. For example. it is recognised that the land reform urgently needs to be completed (Chapter 3), and that the system of provision of farm services needs to be restructured (Chapter 6). On the other hand, the very fact of low profitability in agriculture and agro-industry has hindering the provision of credit to the sector (Chapter 5) and has been holding back needed investments in marketing and processing activities.

III. Issues and Constraints for Agriculture in the Area of Prices and Trade

A. Basic Policy Issues

It is recognised that not all farmers and types of production will be able to make a successful transition to the market economy. As a rule, those who succeed in dealing with the profound changes in the policy environment, and those products which continue to be produced, will be the more efficient ones. For the long run, surely this will be a healthy outcome. The sector's representatives understand that it is imperative to become more efficient in order to be able to survive economically. Indeed, in a very fundamental sense this Strategy can be regarded as a programme for overcoming the structural problems in all areas of the sector and making it more efficient. The efficiency goal is not doubted.

However, policy has wide latitude in determining the threshold between “efficient” and “inefficient” enterprises and activities. It is analogous to setting the height of the bar for high jumpers, in order to determine which athletes qualify for further rounds of competition. Setting the bar high means most of the producers will fail, and setting it lower allows more of them to continue.

In general, EU countries have set the bar rather low for agricultural producers, compared to other countries in the world. Initially through tariffs and controls on prices and trade, and increasingly through direct support measures, the European countries have decided to adopt a rather generous interpretation of what is an efficient operation in agriculture.

Estonia probably has set the bar higher than any other country, for its farmers. To date, it has no direct support measures, no controls on prices and trade, no tariffs to speak of, and a real exchange rate which penalises exporters and favors imported products. It is hard to identify another country which has created an environment of macroeconomic and trade policy in which it is so challenging for farmers to survive economically. In addition, this policy has been carried out at a time when the sector's institutions still are struggling to complete its transformation from a planned economic regime to a market economy, particularly in the areas of land tenure policies and farm support services. Had that transformation been completed, or given more assistance, it would be more feasible for farmers to survive in the current policy environment.

Therefore a major policy issue with respect to the agricultural sector is: Where is the threshold of efficiency to be set? In practical terms, this means: What are the most appropriate policies for tariffs, direct support and the exchange rate? This Strategy is a forward-looking document, and its goals are to create an Estonian agricultural sector which is robust and capable of surviving under varying international circumstances in the future. Therefore, it does not advocate a protectionist policy that will create inefficiencies and a lack of competitiveness. However, given that Estonia plans to join the EU, a logical question is whether modest tariffs and a programme of direct support (known as the McSharry Plan in the EU) are not appropriate. Equally, if the balance of payments trends are suggesting that the exchange rate policy is not sustainable in the long run, is it wise to maintain it in the short and medium run, given that it makes it very difficult for the agricultural and manufacturing sectors to compete on world markets, and to compete with imported products?

These are not questions that admit of simple answers, and the interests of the entire economy must be taken into account in answering them, but the work of this Strategy suggests that it is important to assign priority, to reviewing these questions and carry out national deliberations regarding the alternatives.

Before dealing with these issues, a fundamental question is whether the agricultural sector has the economic potentialto be competitive internationally. If it does not, then agricultural policy must necessarily emphasise transitional subsidies for the rural population while agricultural activity is phased down to a very low level. If it does have potential, then the challenge is to reform policies so that they support the realisation of that potential. This basic question is analysed quantitatively in section V of this Chapter.

B. Constraints in the Area of Prices and Trade

Clearly a major constraint on the development of our agricultural sector is the pervasiveness of the international agricultural subsidies which has been mentioned above. When grains, livestock products and other products can be shipped to our shores at prices that are well below production costs in their countries of origin, a major constraint is placed on the prospects for our agricultural development. However, we are not alone in facing this problem, and solutions can be found.

Another external constraint is that much of our former Eastern market effectively has been denied to producers. This factor alone would have made the economic transition for agriculture extremely difficult. It is to be hoped that a combination of direct negotiations and eventual accession to the EU will solve this problem.

Internal constraints to the development of the agricultural sector are described fully in the succeeding chapters of this Strategy. From an overall viewpoint, some of the more important of them are the following:

• The incomplete state of the land reform, which means that most of our farmers do not have full tenure rights to the land they are working.

• The deteriorated state of the land amelioration (drainage) systems, which is a serious concern, given that most of our agricultural land requires drainage in order to be usable.

• The incomplete transformation of the system of provision of farm support services, which means many vital services are supplied unsatisfactorily or not at all.

• The out-of-date technology used in much of our food processing industry, which makes it difficult for us to satisfy quality standards in Western markets.

• The insufficiency of private, credit for agriculture, and the lack of financial institutions that are more appropriate for meeting the credit needs of the agricultural sector.

• The deteriorated state of our fishing fleet.

• The inadequacy of social policies for farming families and rural areas in general.

This Strategy attempts to define policies and programmes for overcoming these constraints so that the agricultural sector can recover its role in the Estonian economy and society.

IV. Macro Policy Objectives for the Agricultural Sector

The principal policy objective in this area is to improve the economic incentives for agricultural production, including fisheries and forestry, within the framework of balanced growth for all sectors on the economy. It is not expected that all of the decline in incentives since 1992 can be recovered, but some of it should be. The economic trends of recent years, which have been wholly in favor of the service sectors and of urban consumers, must be changed. Neither are special privileges sought for agriculture. Agriculture should not be an economic parasite on the rest of the economy, but on the other hand it should not be exploited by other sectors. A more appropriate balance in our economic growth pattern should be the national goal for economic management.

The broad objective for this Strategy is to improve the quality of life in rural areas. This goal has acquired greater national urgency, since poverty and its associated problems have worsened particularly in rural areas. Within this context, the role of macroeconomic policies is to establish a framework in which farming can become more prosperous, without going to the extreme of some countries in terms of measures which are very costly to the government budget or which produce very high food prices for consumers. With a modest improvement in incentives and with better supporting programmes, Estonian agriculture can realise its very considerable potential.

V. Analysis of Price and Trade Policies for Agriculture

A. Estonia's Agricultural Comparative Advantage

The most basic question to be answered about agriculture is whether it has the potential to be competitive vis-a-vis world markets in the future. As indicated in the foregoing discussion, the currently high agricultural prices within the EU are likely to be reduced, and the abnormally low international prices for many commodities are likely to rise as a result of further rounds of international trade negotiations. Therefore long-term trends in international prices will become increasingly the benchmark against which the costs of production in Estonia should be measured.

If analysis of cost structures were to reveal that Estonia does not have the potential to be competitive (a comparative advantage), then it could be concluded that the present governmental policies of promoting almost exclusively the service sectors are correct, pending an analysis of the manufacturing sector's prospects also. But if it is determined that indeed agriculture does have the potential to survive and compete in an international framework, then it must be asked why the present policies are so deleterious to agriculture's prospects, and corrective policies should be put in place.

Recently an analysis of the comparative advantage of Estonian agriculture was carried out on the basis of price and cost data for the years 1994 and 1995.⁸ That study calculated the measure called the coefficient of domestic resource costs, or DRC for short. The DRC measures how much in domestic resources it costs to earn a unit (dollar) of foreign exchange by exporting, or to save a unit of foreign exchange by substituting domestic production for imports. In calculating the cost of domestic resources, average production technologies have been used, so undoubtedly the situation will be somewhat different for individual farmers. Also, this measure abstracts from current taxes, tariffs and subsidies (although they are very few), so that truly long-run competitiveness can be measured.

⁸ S. Yao, op. cit., 1997.

After the cost of earning or saving a unit of foreign exchange are calculated, they are divided by the exchange rate (kroons per dollar in this case), to arrive at the DRC itself. Thus if a product has a DRC of less than one, it indicates that by exporting that product it costs Estonia less to earn a dollar of foreign exchange than it would cost to acquire the dollar in the foreign exchange markets. In such case, the product is said to have a comparative advantage. Similar conclusions are reached if an import-competing product has a DRC of less than one. On the other hand, a DRC greater than one indicates that the product would not be competitive in the long run, and thus does not have a comparative advantage.

If a product had a DRC of 0.75 in 1994, when the dollar exchange rate was 13.0, then it would have cost kr 9.75 ( = 0.75 × 13.0), in national resources, to export the product, or substitute it for an import, and that activity would have gained kr 13 for the country. Hence there would be a positive net gain and this product clearly would have economic potential.⁹ Full details of the methodology are available in the cited study.

⁹ The unit of foreign exchange earned or saved is net of imported input costs.

Table 2-8 provides the principal results of the analysis of comparative advantage. A cautionary word should be mentioned in the sense that results of this kind for only 2 years can sometimes be misleading, and also there always is a margin of error in the calculations. Nevertheless. for most products, the results are sufficiently clear that they probably can serve as guides to policy.

Of the 15 products analyzed, 11 have a clear comparative advantage. It is strongest in pulpwood, sawlogs, sawnwood, potatoes, barley, oats and sprat and herring, but it also is very significant in wheat¹⁰ and plywood. These calculations confirm what many agricultural experts have said, that Estonia has definite long-run potential in these products, some as export lines and the grains as substitutes for imports.;

¹⁰ Adjustments have been made in these calculations for the quality differences between imported wheat and some of the domestic wheat.

The results for milk show a decided comparative advantage as a substitute for imports. In the case of exports, the results were mixed due to fluctuations in world market prices, but the average result for 1994 and 1995 also indicated a comparative advantage. If world market prices were to rise as a result of a negotiated reduction in subsidies to dairy farming in other countries (Table 2-4), then Estonia's comparative advantage in milk would be even clearer. More generally, taking into account the presence of heavy international subsidies in dairying, vs. none in Estonia, it can be said that Estonia has a strong comparative advantage in dairying in the truest sense.

The potential of beef production is weaker. Except for some specialised sub-products and markets, these results suggest that beef does not have a comparative advantage for export. As a substitute for imports its position is questionable, and productivity improvements would be required for it to attain a clear comparative advantage.

Pork's situation is weaker than that of beef. Its lack of comparative advantage no doubt is due to the necessity to use purchased feeds for a good part of the year. It should be recalled also that intensive pork production causes environmental problems (Chapter 7). Poultry turns out to be the least competitive product among all those analyzed.

These results do not imply that all producers of pork and poultry are non-competitive by world market standards, for they refer to industry averages. However, they do suggest that Estonian resources would be more productive if, over time, they were reallocated away from those lines of production and towards the others that do have a comparative advantage. From another viewpoint, the results suggest that policy should not try to stimulate pork and poultry production, but rather should concentrate on other products, for the national benefit. Estonian consumers would find imported pork and poultry to be cheaper, and Estonian resources would be more effective if used in expanding production for export, and import substituting production, in other lines. Total agricultural income will increase to the extent that the composition of sectoral output is shifted toward those products that have a comparative advantage.

Table 2-8.
Comparative Advantage (DRCs) of Principal Agricultural Products¹¹

¹¹ See text for definition of DRCs. In the results reported in this table, the market value of agricultural wages has been used. The cited study also reports results with a lower wage.

A major caveat to these results is that they use the existing nominal exchange rate in making conversions of international prices to domestic currency, and vice-versa. Hence they report the comparative advantage of Estonian agriculture conditioned on the present exchange rate policy. IT the exchange rate were to be different in the long run, the competitiveness of Estonian agriculture could be enhanced significantly.

In order to illustrate the influence of the exchange rate on comparative advantage, Table 2-9 below analyses how the results reported above would differ if, as a purely illustrative example, the exchange rate were devalued by 20% in real terms. In this table, the DRC under the revised exchange rate is shown in boldface type. The results were repeated under this hypothetical scenario only for a few products where the comparative advantage was doubtful or not as clear as in the case of the others. Obviously, the devaluation scenario would increase the already strong comparative advantage of the other products.

Table 2-9.
Comparative Advantage under an Alternative Exchange Rate Scenario

Source: Adapted from Yao (1997), under the scenarios using actual wage rates.

It can be seen from Table 2-9 that a movement in the exchange rate would remove the slight doubt that hangs over milk as a competitive export. It also would improve the situation of beef as a substitute for imports, but nevertheless it would appear that beef production still requires productivity improvements to be fully competitive. Under the scenario of the revised exchange rate, pork and poultry show some possibilities in competing with imports, and data from more years would have to be analysed in order to draw more firm conclusions.

The general conclusion is that agriculture definitely has a place as a productive sector in Estonia's future, more for supplying the domestic market (competing with imports), but still some products also show clear competitiveness as exports. The advantages that agriculture enjoys in this sense would be enhanced by a real devaluation of the exchange rate.

B. The Macroeconomic Framework and Options

The Framework

The principal macroeconomic policy choices made in 1992 were:

1. to fix the exchange rate in nominal terms, ••'
2. to require that the Government budget be balanced,
3. to back the domestic currency with foreign exchange reserves,
4. to liberalise completely external trade and capital transactions, and
5. to make the Estonian kroon completely convertible.

Other, complementary decisions were made in regard to the management of monetary and banking policy. To date, these policies already have brought some clear benefits to Estonia, perhaps primarily the following:

1. a substantial reduction of inflation from initially very high levels,
2. a large inflow of foreign direct investment, especially in the manufacturing sector, and
3. an expansion of output and employment in the service sectors of the economy including, for example, the emergence of a relatively strong private banking sector.
4. An increase in the average productivity of the employed work force.

To these benefits can be added the expectation that inflation will continue to decline, because of the legal restriction on the Government budget deficit.

From a viewpoint of promoting economic growth, there are two other effects of the current macroeconomic policy that also are fundamental and must be reviewed:

1. an appreciation of the real exchange rate,¹² in the cumulative amount of 262% from June, 1992, to June, 1996, and
2. because of that appreciation, a large shift in intersectoral relative prices in the economy, as mentioned in Section I above.

¹² In this context, the real exchange rate is the current (nominal) exchange rate adjusted for the differential between Estonian inflation and a weighted average of inflation in Estonia's international trading partners. An appreciation of the real exchange rate means that Estonian incomes are rising in their purchasing power over foreign goods. By the same token, it means that foreign goods are becoming cheaper relative to Estonian goods and therefore imports tend to displace domestic production, and Estonian exports weaken because they are becoming more expensive in foreign markets. An appreciation of the real exchange rate can fee avoided only if the nominal exchange rate moves upward when domestic inflation exceeds the inflation in the trading partners.

One of the principal roles that the exchange rate plays in an economy is to determine relative prices between sectors. An appreciation of the real exchange rate always increases the relative, or real, prices of the non-tradeable outputs (largely services) and decreases the relative prices of tradeable outputs, which are mostly those produced in agriculture, fisheries, forestry, mining.: and manufacturing. This cause-and-effect relationship has been documented worldwide for a very large number of countries.

The consequences of the appreciating real exchange rate (stable nominal exchange rate in the face of domestic inflation) can be seen clearly in the intersectoral transfers of income mentioned above.

While these effects have been mostly negative for agriculture, it is important to maintain objectivity in the analysis and recognise that the reduced real prices for agriculture have created incentives to make fanning more efficient, and indeed a few commercial farms have responded well to the challenge. This undoubtedly is a positive development for the future of Estonian agriculture. However, if reduced real prices are a kind of medicine for an ailing patient, then it must be- asked whether too large a dose may not kill the patient. A tendency in this direction has been seen in the above mentioned effects of many bankruptcies of farms and agroindustries, rural land values that arc too low to serve as bank collateral, and extensive amounts of abandoned farmland in some regions of the country.

As commented, these considerations demonstrate that the current mix of macroeconomic policy is one that favors growth of the service sectors, encourages labour to migrate out of agricultural work to urban service jobs, encourages imports and makes exporting relatively more difficult, reduces the standard of living of rural households, and puts a great squeeze on profits in mining, manufacturing and agriculture (including forestry and fishing).

In 1939 Estonia's standard of living was comparable to that of Scandinavian countries at that time. Now urban Estonia is rushing to reach those levels again and rural households are lagging far behind, most of them in markedly worse economic conditions than they were a few years ago.

There is a generational dimension to this dilemma. It is relatively easy for young persons to leave the farm and learn to use computers and other skills required in office jobs, but their parents are not so adaptable. Hence many observers have pointed oat that the worsening rural poverty is concentrated in older persons, especially those that depend only on a household plot for sustenance.

As a consequence, agricultural producers are becoming increasingly strident in their demands for a change of policy, or for some kind of economic compensation for the effects of policy. In fact, Parliament gave a partial response to those demands in the form of the Agricultural Market Regulation Law, passed in October of 1995, which so far has not been implemented, but the voices calling for policy change continue to be heard.

To safeguard Estonia's prospects for economic growth, it is essential that the policy response to these demands take an appropriate form, and not a form that creates new sources of inefficiency in the economy. For that reason, the following sub-section reviews a broad spectrum of choices, even the most fundamental ones. It is important that the alternatives be presented and discussed at least in concept, even if some of them are not adopted.

Under any package of reforms, it also is vital to preserve the gains that have arisen from the present policy framework, especially with respect to productivity, which is the only basis of growth in real incomes in the long run.

Macroeconomic policy options for agriculture

There are various kinds of successful macroeconomic policy. As pointed out, the present policy has had some notable successes to its credit already. Unfortunately, it has been prejudicial to the so-called productive sectors (those that produce goods rather than services) in the economy, with some negative social effects as well. In a word, the present policy has been fairly successful in achieving stabilization but has not been able to generate growth of incomes and employment.¹³ The challenge is to devise policy reforms that preserve the most positive results of the present policy while correcting the negative effects for agriculture (and for manufacturing also, if possible). This section outlines major scenarios for policy reform, to establish the macroeconomic framework for the National Agricultural Strategy.

¹³ Preliminary estimates for 1995 indicated a real GDP growth of 2.9%, after a decline of 2.7% in 1994 and larger declines in 1992 and 1993. This turnaround is a welcome development but it is. still too early to say whether the engine of growth has started to move, and to move at an acceptable rate. Regarding employment, it should be noted that the official unemployment statistics understate the true amount of unemployment: see the UNDP's recent Human Development Report for Estonia.

Broadly speaking, at conceptual level four kinds of macroeconomic policy can be conceived, in terms of their growth-promoting effects at the sectoral level:¹⁴

¹⁴ Listing these options does not imply that other options which imply expenditures from the national budget, such as building rural infrastructure, are not important also. They are important; for expositional purposes, the list here includes only the purely macroeconomic alternatives, without minimizing the importance of sector-level options.

1. Macroeconomic policy that promotes, via better incentives, agriculture and manufacturing in all branches; this will be called macroeconomic policy to promote the productive sectors.

2. Policy that shields the industries and products that face competition from imports, but not the exporting industries and products. This will be called policy favoring import substitutes.

3. Policy that compensates all agricultural activities for part of the cost of the present policy; this option may be termed a compensatory policy for agriculture.

4. Policy that protects agricultural profits at the cost of introducing price rigidities; this option can be called the price management policy.

By way of introduction, it should be reiterated that these options are presented and discussed in this document for informational purposes only, at a technical level, in full awareness that it is the responsibility of the Cabinet and ultimately of Parliament to make policy. The intent of the document is to provide technical information that is relevant to the ongoing policy deliberations and debates, by clarifying options and their implications, and in no way to intrude upon the decision making powers of the rightful authorities. On the other hand, these issues are of sufficient national importance that further technical contributions to the discussion should be encouraged.

Macroeconomic policy utilises several policy instruments. The first macroeconomic option would represent a fundamental revision of a basic instrument of present macroeconomic policy while maintaining others. The other three options represent a continuation of the main thrust of current policy but a change in some other elements of it.

The four options, respectively, represent modifications of the following instruments of macroeconomic policy:

1. Exchange rate policy.
2. Tariff policy.
3. Fiscal (tax and subsidy) policy.
4. Price policy.

Option 1: Macroeconomic policy to promote the productive sectors

This policy basically would consist of devaluations of the nominal exchange rate in order to correct part of the excessive appreciation of its real level. Most countries in the world allow exchange rate corrections to take place when their inflation persistently exceeds that of their trading partners. This policy does not assume that the goal of fixing the exchange rate with respect to European parities is invalid in the longer run; on the contrary, that goal would be consistent with the stated intention to join the European Union. The question is whether, in retrospect and in view of the unexpectedly high cumulative inflation that has occurred since June of 1992,¹⁵ the fixing of the nominal exchange rate has not proven to' be premature. Finland, which has a considerably higher income level, fixed its rate only after letting it float for four years, and even so there is a strong national debate on the issue, in light of Finland's 17% unemployment rate. It should also be recalled that some experts consider that Estonia delayed its devaluation in the early 1930s too long, to the great detriment of employment and income levels in the productive sectors and the economy as a whole.

¹⁵ It may not be possible to know how much inflation the monetary authorities expected to occur after fixing the nominal exchange rate, but it is almost certain they did not expect it to be anywhere near the amount of 428%, which was the inflation registered in the consumer price index from June of 1992 to June of 1996 (and is continuing).

Therefore this policy scenario would involve progressive devaluations of the exchange rate¹⁶ for a period of a few years, and then fixing it anew when both domestic prices and the exchange rate have more or less stabilised. The cost would be a slower rate of decline of inflation, i.e., more time required to achieve full price stability. But with a low-Government budget deficit (currently around 2% but scheduled; to fall to zero), which is very much in Estonia's favor, the inflationary consequences of .devaluations are transitory and proportionately less than the devaluations themselves. Ultimately, both price levels and the exchange rate would stabilise at a new, higher level.

¹⁶ In practice, devaluations can be brought about in many ways. Two examples are: a) free the rate and lower interest rates; and b) control the rate at progressively devalued levels. An exchange rate cannot be controlled at overvalued levels without creating a black market in foreign exchange, but it can be controlled in the direction of increasing undervaluation, as many East Asian economies have done in the past.

The advantages of such an approach to policy would include: higher real prices for agriculture and manufacturing (and therefore for agroindustry also), higher output and income growth in those sectors, higher employment growth in those sectors, and less rural poverty. Service sector growth undoubtedly would slow somewhat, but international experience has shown that the net effect on the economy's growth would be positive.

In principle, the devaluations would continue until the real exchange rate attained a long-run equilibrium. It is hard to judge what such an equilibrium level would be, because while foreign investments may diminish eventually in proportion to the size of the economy, in the meantime they tend to sustain a short-run equilibrium of the exchange rate. Purchasing-power parity calculations may shed some light on the issue, but an alternative approach is to adopt the goal of inducing a given amount of increase in the index of real agricultural prices. It is clear that not all of the 50%+ decline in that index can ever be recovered, nor even most of it. However, it would not be unreasonable to adopt a policy goal of increasing the index by 10% to 20%, say about 15%. Informal evidence at the farm level suggests that such an increase could make many more farms profitable and therefore viable. A similar effect would occur in agroindustry and the rest of manufacturing,¹⁷ perhaps to a slightly lesser extent in manufacturing because it is more intensive in use of imported inputs.

¹⁷ While a devaluation would increase the costs in kroons of imported inputs into agriculture and manufacturing, it would increase the price of their outputs (in kroons) in the same proportion in most cases, because they are competing with imports,' or are exporting, or are substitutes in production or consumption for other goods which do compete internationally. Therefore, because imported inputs represent only part of the cost of production, net profits would increase. Labour and other domestic inputs would increase in price as well, but by less than the outputs of these sectors.

This policy option could also be called the one of maintaining Estonia's international competitiveness, because it would give additional price incentives to Estonian exporters and to those sectors and subsectors that compete against imports. It would strengthen Estonia's comparative advantage, as indicated in the foregoing analysis of that topic. Viewed in this light, in effect the present national policy has conferred an economic advantage on producers in other countries., although that was certainly not its intention. This is a serious problem, because given the small size of Estonia's domestic economy, it must expand its exports rapidly in order to grow and prosper.

It should be underscored that this policy option would maintain fully Estonia's commitment to a liberal economy. It would preserve the free trade policies and confirm the lack of protectionism, and it would serve to dampen the calls for fiscal subsidies to agriculture, by virtue of increasing agriculture's profitability. While it would represent a departure from the fixed nominal rate of exchange, it would move to stabilise the real rate of exchange and in all other respects would maintain the guidelines of present macroeconomic policy.

If it is decided for compelling national reasons that the devaluation option is not feasible, then one of the options developed below may be considered

Option 2: Policy favoring import substitutes

This policy option would utilise the instrument of import tariffs, imposing tariffs as . means of inducing a rise in the prices of domestic products which compete with imports. It already has been proposed as a way to implement the Agricultural Market Regulation Law, and a relatively high tariff ceiling has been negotiated with WTO.

The situation of the exchange rate makes the calls for tariff protection almost irresistible, and certainly tariffs would improve the profits of import-competing activities (e.g., cereals). However, the imposition of tariffs would mark a significant retreat from the liberal (open) policy orientation, much more so than a movement in the exchange rate would. And it would bring with it important disadvantages, most notably an increase in the costs of production for industries that use as inputs the products of the protected sectors.. Note that these objections do not apply to the products that would be protected by countervailing duties, for the purpose of offsetting subsidies in exporting countries.

Therefore a tariff policy tends to work against export sectors (such as dairy products, wood products and fish), because by raising the costs of some of their inputs it makes them less able to compete on world markets, and they receive no compensation in the form of higher output prices in kroons, as they would under a devaluation. If import tariffs were applied very selectively to only a few agricultural products, then this kind of consequence could be minimised, but once a tariff policy is instituted, it is hard to avoid its extension to many products. Another disadvantage of tariffs, in the form in which they are usually established, is that they favor some products more than others, and those favored products may not the ones that have the brightest future prospects.

These disadvantages can be ameliorated somewhat by making the tariffs relatively modest and as uniform as possible over the commodities that are protected. In that way, Government would not be attempting to “pick the winners” among the subsectors, but rather it would let market forces determine which lines of production prosper and expand, and which ones contract. This is the best way to respect comparative advantage and enhance the economy's growth prospects.

It should be emphasised that, strictly in terms of economic efficiency, the tariff option is inferior to an explicit devaluation. However, if the rigidity of the nominal exchange rate is maintained, then this option could be important for some parts of agriculture, mostly the grain producers.

Option 3: Compensatory Policy for Agriculture

In the EU there has been a shift in policy thinking, away from measures that attempt to influence prices that producers receive, and toward direct economic compensation of the producers. This is part of a general concern to move away from policies that distort prices from their market-determined levels. The WTO also endorses instruments of direct compensation, as opposed to price-distorting measures.

In the Estonian context, such a policy could take the form of direct payments to producers, per hectare of land in cultivation (or in a fallow cycle). Again to give the hypothetical policy a concrete illustration, payments could be made of about kr 1000 per hectare for a fifteen-year period, as a compensation for the decline in real producer prices that has occurred. Comparable sums could be provided per cow to beef and milk producers, and per boat to fishermen. It may be desirable to try to give small (lower-income) producers a proportionately greater compensation by, for example, putting a cap on a farm's total land area eligible for the programme, say of 100 or 200 hectares. Alternatively, the payment per hectare could be reduced for land in excess of 100 hectares in any one farm.

Such a policy could be linked to other programmes. For example, it could be utilised to speed up the process of land reform by making the titling of the land a condition for receiving the payment, independently of whether the title is given .to an individual farmer or to an enterprise. Consideration also should be given to incorporation of private forest lands, and lands in reforestation, into the programme, because in the long run forestry appears to be a sector which has considerable potential, and it is important that policy instruments do not discriminate against it.

If appropriate implementation mechanisms could be found, eventually the payments made under a programme of this nature could be linked, at least in part, to the adoption of environmentally sound practices at the level of farm and forest.

It is worth noting that not only is such a policy being instituted in Western Europe, but that Mexico launched such a programme in the early 1990s, before the devaluation of the peso, when Mexican producers felt a strong need for compensation as a condition of entering the North American Free Trade Agreement. The agreed level of payment was US$100 per hectare, with no ceiling on farm size for eligibility in the programme. While the Mexican economy is very different than Estonia's, there is an illustrative parallel in the sense that both agricultural sectors have felt disadvantaged by the exchange rate when participating in the arena of international markets.¹⁸

¹⁸ Now Mexican farmers and exporters are strong advocates of a competitive exchange rate policy. “Exporters ... are worried that unless something is done to weaken the peso, their competitiveness could quickly be eroded” (The Economist, June 8, 1996, p. 80).

How would such a programme be financed, respecting the requirement that the Government budget not enter into a deficit? Since exchange rate policy has caused an intersectoral transfer of resources, away from agriculture and into services, the logical approach would be to tax the private service sector (banking, wholesale and retail trade, .construction, business services, hotels and restaurants, transportation, etc.), at a rate designed to raise the revenues for the compensation programme. Thus, this option would rely on the mechanism of fiscal transfers to be put into effect. As envisaged, these direct payments would be in addition to expenditures on rural infrastructure and farm support services, which should occur in any event.

This policy option has the significant advantage of being neutral with respect to prices, thereby avoiding distortions in relative prices and not putting some sectors, such as exporting activities, at an economic disadvantage. At the same time, it would go a long way toward restoring profitability to agriculture.¹⁹

¹⁹Special provisions would have to be made for the poultry industry, which uses very little land per unit of output, to be sure it were not disadvantaged in the programme, and for the fisheries sector. For the latter, the payments might be scaled to the size of the fishing vessel.

There is an important variant of this option, which may be called option 3a. It consists of capitalisation of the direct payments so that a farmer, forester or fisherman may utilise the corresponding lump-sum payment for purposes of purchasing equipment or making other investments, without needing recourse to bank financing, which is difficult to obtain in these sectors. Under this variant, the producer could elect to receive a high-interest Government bond, which would be quite distinct from the vouchers used to compensate landowners in the land reform progranune. The bond would pay attractive rates of interest so that it could be sold by the producer for its face value to a bank or private individual (including foreigners), thus raising a capital sum for the producer. The face value of the bond would be calculated as the present value of the 15-year Time stream of payments. The mechanism of the bond is recommended in order to avoid placing too much pressure on the Government budget in a single year. In effect, the capitalised sums would be provided by private financial markets, and the Government would make its contributions over the 15-year time horizon.

In sample numbers, the mechanism would work something like the following. Suppose an enterprise held 100 hectares and the direct payment plan envisaged payments of kr 1000 per hectare. Then under Option 3, the enterprise could elect to receive kr 100,000 per year. Alternatively, under Option 3 a, it could receive a bond whose face value were 700,000, if a discount rate of slightly over 14% were used. The Government would pay the bondholder 14% per year on the face value, or 98.000.²⁰ The producer could then sell the bond for approximately 700,000 and use the resulting funds to capitalise the farm or forestry operation, or purchase fishing gear.

²⁰ It is necessary to make the annual return to the bond holder slightly less than the annual direct payments under the original Option 3, so that not all producers choose Option 3a. If all of them chose 3a, the bond prices might fall significantly because of the additional pressure they would collectively place on available savings. This is the main reason for allowing the possibility of selling the bonds to foreigners. It may turn out that the present value of the bonds has to be calculated with a higher interest rate, and perhaps their yield may have to be higher also, in order to preserve their value. This would be a matter to be decided after careful analysis of the situation of financial markets in Estonia.

Another variant of the direct support option would be to provide a higher level of support for the first few hectares, in order to give proportionately more benefits to middle-income and lower-income farms (which represent over three-fourths of all the farms in the country). For example, the support level could be set at kr 2000 per hectare for the first ten or twenty hectares of a farm, dropping to kr 1000 per ha. for additional hectareage. This variant would effectively make the subsidy progressive, targeting it somewhat on the middle-income and poorer rural households. It could be combined with the variant of capitalisation of the direct payments.

Option 4: Price management policy

This option also has been advocated recently as a way to improve agricultural profitability. It would consist of establishing guaranteed levels of prices and then, if necessary, the State would purchase harvests to sustain that price. Of course, this kind of policy has been in effect in Europe and other countries for a long time, but its disadvantages are increasingly being recognised. As a consequence, its use is being reduced worldwide.

The price management option would have to be combined with tariffs for those commodities whose prices were controlled, to avoid giving incentives to import for the purpose of selling at the guaranteed price.

In Estonia this policy was attempted in 1992, for the price of rye, but it was necessary to abandon it because of the inability to predict in advance a price which would bring supply and demand into equilibrium. That problem is inherent in such programmes. Another problem is rooted in the methodology of establishing the guaranteed prices: they usually are calculated as a function of estimated costs of production. However, this means that the guaranteed prices will rise as production costs rise - inefficiency is rewarded! Equally, which farms' costs of production are to be used, the more efficient ones or the less efficient ones?

Another disadvantage is the possibility of significant and unpredictable net fiscal costs, depending on the supply response, the consequent storage requirements, and the market-clearing price for consumers. Yet another problem is the fact that not all farmers have equal access to the guaranteed price, and typically smaller farmers are discriminated against, for they do not have the same means to transport their products to collection centers that larger farmers do. Hence, to the extent that the programme contains a net subsidy for agriculture, that subsidy turns out to be regressive, i.e., proportionately concentrated in the larger farms.

Finally, it should be pointed out that this kind of programme would suffer the same disadvantage that selective import tariffs alone would, in the sense that it favors some products over others, and those which are favored are not necessarily the ones with the best growth potential. Often they are the commodities whose producers are in greatest difficulties, precisely because they will be least competitive in the long run. Thus price supports and tariffs may inhibit the process of allocating resources to their most efficient uses within the sector, and this is a very important disadvantage from a viewpoint of the country's growth prospects.

Concluding Observations on Macroeconomic Policy Options for Agriculture

This section of this document has attempted to review the essential features of the macroeconomic framework from a viewpoint of promoting agricultural growth. The point of departure is the fact that the nominal exchange rate was fixed at an arbitrary level, not necessarily sustainable in the long run, and that continuing domestic inflation has consequently placed domestic producers at a competitive disadvantage vis-a-vis international markets. The fixed nominal exchange rate has driven a realignment of relative prices within the economy, much to the disadvantage of agriculture. Accordingly, it has led to an intersectoral reallocation of resources that does not necessarily conform to either Estonia's long-run comparative advantage or its vision of the kind of economy and society it would like to build.

While the advantages of the present policy in terms of relative stability and inducements for increased efficiency are recognised, it has contributed to an economic situation in rural areas which is very difficult, with increasing social problems as a result. In the circumstances, pressures are understandably building up for a change in some aspects of the policy.

This analysis leads to the conclusion that some of the remedial measures proposed would cause significant economic damage as well as benefits, particularly the proposals for tariffs, unless they are modest, and/or guaranteed prices. Options that would have more positive effects on Estonia's growth prospects include:

• Option 1: Revision of the exchange rate.
• Option 3: Compensatory direct payments to farmers, foresters and fishermen.
• Option 3a: Compensatory direct payments with the possibilities of capitalisation, and/or
• Option 3b. Compensatory direct payments including a degree of targeting on subsistence farms.
• Option 2: Relatively uniform and modest import tariffs, with perhaps higher tariffs where countervailing duties are needed to offset subsidies in exporting countries (e.g., wheat, beef).

This analysis has outlined the principal implications of each option, as a contribution to the discussions of these important issues. Ultimately, the responsible policy authorities will choose the most appropriate option, or combination of options. It should be emphasised that this Strategy formulates many important policy options at the purely sectoral level.

In closing this section, a comment is appropriate on the notion of countervailing tariffs, or duties, which would be aimed at offsetting subsidies in exporting countries. These subsidies are universally regarded as distortions to world markets, and the WTO is working actively to reduce them. While they still are present, Estonia is not obligated to accept the correspondingly subsidised prices at face value as guides to its international competitiveness. Cereals and milk are outstanding examples of products whose international prices which reflect subsidisation. Countervailing duties or direct support payments to producers would represent a legitimate response on the part of Estonian agricultural policy to this circumstance.

Some analysts argue that such duties would cause more economic harm than benefit in Estonia, by penalizing consumers. However, that line of reasoning is static in nature and overlooks a more important dynamic argument, which is the following:

The international agricultural subsidies may be regarded as a transitory phenomenon; certainly the successive international trade agreements have aimed to reduce them, and in fact reductions have occurred. Most observers expect the downward trend in those subsidies to continue. On the other hand, accepting those artificially low prices in Estonia in the meantime would have the consequence of accelerating the reallocation of labour from rural to urban areas, and this is a flow that is not easily reversible. Once the international subsidies were eliminated, and world agricultural prices rose as a result, it would be very difficult to attract urban dwellers back to rural areas in Estonia. In effect, Estonia would be making a permanent structural change in its economy and society in response to a transitory international circumstance. That kind of policy would be hard to justify and, moreover, could be termed irresponsible.

Furthermore, even if the downward trend in international agricultural subsidies cannot be taken as given, the basic fact about them is that they are under the control of the governments of major exporting countries. Therefore, the question may be posed in this form: whether it is appropriate for Estonia to acquiesce in circumstances (e.g., artificially low import prices of cereals) which can be changed at any time by policy decisions made elsewhere in the world, when such acquiescence means causing (or intensifying) permanent structural changes in its own economy and the society.

C. Analysis of Policy Scenarios

An analysis of options similar to these has been made recently in the context of alternative scenarios for the year 2000.²¹ Additional policy variants were studied to make the analysis realistic in terms of the kinds of policy choices exercised in the EU. Some of the principal options reviewed include: fixed vs. variable exchange rate, countervailing tariffs, and countervailing direct support.

²¹ S. Tarditi, Estonian Agricultural Policy Options, paper prepared for the Estonian Government and the FAO, 1997.

The scenarios are defined as follows:

• A fixed exchange rate refers to the current policy of a fixed nominal exchange rate in terms of DM. A variable rate would move parallel to the movements in domestic inflation.

• Countervailing tariffs would be designed to exactly offset the international subsidies on milk; i.e., they would be about 40%.

• Countervailing direct support would provide support to producers which is equivalent to that provided by the countervailing tariffs, but it would come from payments from the Treasury, rather than through tariffs which operate by affecting domestic milk price levels.

For the sake of illustration, both of the latter scenarios assume the variable exchange rate.

These options are summarised in Tables 2-10 and 2-11 in terms of their consequences for the projections for the year 2000, for the cases of milk and wheat. It can be seen from the table that the fixed nominal exchange rate scenario is easily the worst from a viewpoint of export levels and producers' incomes, but of course best for domestic consumers. Estonia's net agricultural exports are substantially improved under the variable exchange rate scenario, by 154 million kroons in these two products alone, at 1995 prices (and much more at year 2000 prices).

The two countervailing policies have an additional significant cost to consumers, through the yet higher domestic prices of goods. In the case of milk, there also would be a cost to the Government, because selling milk at a world market price which is below the hypothesised domestic price would require the Government to cover the loss. This policy would amount to an export subsidy and, although it is still practiced in the EU, it would not be recommended because the WTO is working to eliminate such subsidies in all countries.

In the case of wheat, the countervailing tariffs would generate Government revenue. The direct support policy analysed for milk in the Tarditi study is different than the per-hectare (or per cow) policy mentioned above, and because it would have the aim of compensating completely the difference between subsidised and unsubsidised world market prices, it would be very expensive for Estonia. A direct payment scheme per cow could be much less expensive.

The direct support scheme for wheat would be much less expensive, and it would bring significant benefits to producers and to the country's trade position.

Table 2-10.
Alternative Scenarios for the Year 2000: Milk
(Million 1995 kroons except where noted)

²² This “real price” is expressed in 1995 constant prices. In other words, if the nominal price of milk on world markets has not changed between 1995 and 2000, its real value (purchasing power) in Estonia would have decreased substantially because of the accumulated domestic inflation.

²³ This is the cost of the Government of selling the exports on the world market, after having been purchased from farmers at a domestic price which, in this scenario, is much higher than the world price.

Table 2-11.
Alternative Scenarios for the Year 2000: Wheat
(Million 1995 kroons except where noted)

²⁴ Tariff revenues.

(See notes to Table 2-10.)

VI. General Conclusions

The most general conclusion of the analysis provided in this Chapter is that the policy framework for Estonian agriculture merits thoroughgoing review. In effect, our country has been carrying out a structural reform only at the macroeconomic level, without an accompanying programme at the sectoral level. Both our economy's internal dynamic and the need to harmonise our policies with those of the EU would argue strongly for a new approach to macroeconomic policy as it relates to the sector.

Another important conclusion is that it now is clear that Estonian agriculture does the potential to be competitive in the future, and policy should support the development of that potential, rather than hindering it as it has done to date. At the same time, it is very important to mention that the sector needs to undergo its own structural reforms, in areas such as land tenure, farm services, rural social policy, forestry policy and agricultural financial policies and institutions. A full programme for these reforms is set out in the remaining Chapters of this Strategy. The emphasis on the macroeconomic framework in this Chapter is necessary but it does not imply that the sector-level sectoral reforms are not equally important. In the end, increased productivity can arise only from restructuring at the sectoral level. Macroeconomic policy can provide the incentives for restructuring, which are necessary, but they should not be confused with the sector-level restructuring itself.