Mismatches in the Estonian economy have increased

  • Tensions in the labour market have led rapid consumption growth to diverge from slow GDP growth
  • Stimulation of domestic demand by the government would increase the imbalances that have arisen
  • Labour productivity and a reduction in the market share of exports this year may indicate problems for the competitiveness of the Estonian economy
  • Faster Estonian growth will need increased competitiveness and productivity

Growth in Estonia has not accelerated this year and has turned out slower than it was last year. Production capacity in the business sector should make the Estonian economy capable of growing by around 3% this year, but actual growth is forecast to be only 1.2%. It is mainly being held back by weak demand in trading partners, and export opportunities for companies are few and far between. In consequence, less is being invested in increasing production capacity. Economic growth will accelerate in the next two years, but quite modestly to 2.2% in 2016 and to 3.1% in 2017.

The economy has largely grown in recent years on the back of increased employment, but this will not be possible any longer. The unemployment rate has already fallen to 5.2% and the share of people active in the labour market has climbed to its highest level this century among the working-age population. This means that neither of those routes will be able in future to compensate for the shrinking of the working-age population to the same degree. Some easing will arrive when the work capacity reform comes in in 2016, although many of those entering the labour market will probably not find work immediately because they do not have the appropriate skills or knowledge.

Faster growth in the Estonian economy is dependent on a recovery in external demand and on increased competitiveness for companies in foreign markets. Unfortunately the competitiveness of the exporting sector and so the potential for growth of the economy is under more pressure than previously. Even though output is increasing very slowly, rising tensions in the labour market have led corporate labour costs to rise rapidly. Demand from trading partners for Estonian exports will increase in the years ahead but the recovery in demand will be uncertain. If the market share of Estonian exports in foreign markets has been reduced by the deterioration in price-based competitiveness, Estonian exporters might not necessarily get a full share of the increase in foreign demand in the years ahead. This would slow GDP growth and increase unemployment.

The tensions in the labour market have let private consumption grow fast, but this is not in line with the growth rate of the whole economy. Although value added in the Estonian economy is almost unchanged from a year earlier, employment has increased by 4%. Labour costs have continued to rise rapidly at the same time, allowing households to increase their consumption significantly. Falling productivity and rapidly rising wages are not together sustainable. If companies do not succeed in raising productivity, then wages will inevitably have to rise more slowly or even fall.

The faster productivity growth than in the rest of Europe has abated, but Estonia has several advantages that can aid growth. The capacity for growth is supported by prudent public finances and the low sovereign debt, the flexible labour market, lower debt levels in the private sector, and favourable borrowing conditions. Interest rates on loans will remain low throughout the forecast horizon, but there is a risk that Swedish asset prices may fall, which would harm the ability of the banks to obtain funding.

Inflation will accelerate throughout the forecast horizon. The rise in inflation will be broad-based as most commodities prices are currently low. The expected increase in these prices will pass through to consumer prices here concurrently with a rise in the prices of other imports, since trading partners will also see prices rising faster at the same time. Services prices will rise in response to higher labour costs, and around one third of the expected rise in prices will come from higher consumption taxes, as excise on fuel, alcohol and tobacco will increase. Higher inflation will mean that real purchasing power will rise more slowly than wages in future, and consumption growth will slow.

Estonian fiscal policy has been appropriate for the current economic climate, as it has considered that revenues from taxes on labour and consumption have diverged substantially from overall economic growth. Although the tax base for direct and indirect taxes is above its long-term sustainable level, it is important that growth in general government spending be restrained. A fiscal policy that stimulates growth through domestic demand will take the economy even further out of balance. Increased spending should be based on the long-term capacity for growth in the economy, and there should be a clear source of funding for each additional item of spending. The government confirmed in its last budget strategy its commitment to keeping the budget in balance in the medium term, and Eesti Pank forecasts that this can be achieved. The conservative fiscal policy should be adhered to so that fiscal policy can be used if necessary to counterbalance the economic cycle. It will become harder and harder to achieve a balanced budget, as pressure to increase spending will come from the decline in the working age population and a rise in the dependency rate.

Economic forecast by key indicators*
    Difference from June forecast
  2014 2015 2016 2017 2014 2015 2016
Nominal GDP (EUR billion) 19.97 20.46 21.45 22.66 0.0 -0.29 -0.55
GDP volume** 2.9 1.2 2.2 3.1 -1.0 -0.9 -0.5
    Private consumption expenditures*** 3.5 5.2 3.5 2.8 0.6 0.3 -0.5
    Government consumption expenditures 3.0 0.8 1.6 1.5 -2.2 0.1 -0.5
    Fixed capital formation -1.8 -5.8 1.3 4.8 -8.2 -3.5 -1.0
    Exports 1.8 -2.5 1.0 4.9 -4.1 -3.8 -0.8
    Imports 1.4 -2.8 2.8 4.8 -3.2 -2.3 -1.2
Output gap (% of potential GDP) 0.3 -1.1 -1.7 -1.3 0.1 -0.5 -0.6
CPI -0.1 -0.4 1.2 2.9 -0.4 -1.4 0.2
     Core inflation 0.5 0.8 1.1 1.4 0.2 -0.1 -0.5
          Services 1.1 2.0 2.0 2.6 1.1 0.5 -0.4
          Non-energy industrial goods -0.1 -0.3 0.2 0.3 -0.5 -0.6 -0.5
     Energy -4.0 -6.7 -0.7 3.9 -1.8 -4.3 0.6
     Food, including alcohol and tobacco 1.1 1.0 2.4 4.8 -1.2 -2.3 1.1
HICP 0.5 0.1 1.5 3.1 -0.4 -1.3 0.1
GDP deflator 2.1 1.3 2.5 2.4 -1.2 -0.6 -0.6
Unemployment rate (% of the labour force) 7.4 5.9 5.8 7.1 0.0 -0.2 -0.4
Employment**** 0.8 3.3 0.2 -0.8 2.3 1.2 0.1
Average gross wage 5.6 5.1 4.8 5.6 0.5 -0.7 -1.0
ULC 3.7 4.6 1.4 1.2 0.4 0.1 -0.4
GDP per employee 2.1 -2.1 2.0 3.9 -3.2 -2.1 -0.6
Private sector debt, outstanding amount 2.7 4.5 4.3 4.9 1.1 -0.9 -1.2
Private sector debt, outstanding amount (% of GDP) 76.5 78.1 77.6 77.1 0.9 1.2 1.2
Current account (% of GDP) 1.0 1.8 -0.6 0.2 0.7 -0.3 0.5
Budget balance (% of GDP) 0.7 0.1 0.1 0.0 0.2 0.2 0.2
     Cyclical component (% of GDP) 0.1 0.5 0.4 0.1 0.0 0.2 -0.1
     Temporary measures (% of GDP) -0.3 -0.5 -0.3 -0.3 0.0 0.0 0.0
Structural budget balance (% of GDP) 0.9 0.1 0.1 0.2 0.2 0.2 0.2
* Numbers reported are annual rates of change in per cent, if not noted otherwise,
** GDP and its components are chain-linked,
*** including NPISH,
**** employment by domestic production units
Sources: Statistics Estonia, Eesti Pank

Additional information:
Viljar Rääsk
Public Relations Office
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Email: viljar [dot] raask [at] eestipank [dot] ee
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