• Investment has fallen for three years and this has reduced the potential for growth in the coming years
• Funding an increase in government spending from a budget deficit may boost growth in the short term, but may harm competitiveness in the long term
• Improving competitiveness and export capacity is the key to faster growth
• Rapid wage growth overstates the rise in the income level of residents, as it comes partly from a redistribution between capital and labour incomes

Growth in the Estonian economy this year will be the slowest since the economic crisis. One reason growth has been slower is that modest demand in trading partners has limited the opportunities for growth in manufacturing and exports, though the prime cause of weak growth this year has been the problems in individual sectors, with difficulties in oil shale production and the energy industry and lower value added in real estate activities. 

Potential growth in the economy has been decelerated by the reduction in investments in the last three years. Earlier estimates put the potential growth of the Estonian economy at close to 3%, but less production capacity has been added and this has pushed potential growth below 2.5%. This means that convergence with the average income in the European Union will happen notably slower in future than was earlier forecast. The rapidly rising average wage is not an objective indicator for estimating income convergence as it is partly attributable to a redistribution of labour and capital incomes.

Wages rising rapidly when GDP growth is slow can be explained by the better performance of labour intensive sectors of the economy. The majority of the sectors where economic growth has been hindered are capital intensive ones like mining, energy, transport and real estate activities, which steer the labour market relatively little. Development in labour-intensive sectors has been better however, and demand for additional labour has caused wage growth to diverge from GDP growth. On top of this the minimum wage and sectoral agreements have affected wage growth, as has the steady shrinkage in the size of the labour force in Estonia.

Labour market activity is already at a record level and will continue to increase. The work ability reform will add people to the labour market who are highly likely to be unemployed at first, as is indicated by preliminary data. They will probably find an opening after some time and will help ease the labour shortages in low wage jobs, where the lack of workers is most severe. 

Various indicators for wages indicate a slowdown in growth in labour costs. The speed of wage growth has backed off this year. The upwards pressure on wages will not be reduced particularly, as the labour market will continue to be shaped in the years ahead by the main factors behind wage pressures now, which are the lack of qualified labour and the shrinking of the population. The growth in labour costs will probably continue to slow because the business sector has only limited capacity to submit to the stronger position of employees in negotiations.

The decline in prices that had lasted over two years came to an end this autumn, and inflation has started to rise. As wage growth is slowing at the same time, the growth in retail sales and private consumption will be slower than it has been. The household savings rate has been high for the past couple of years and savings have increased enough that a sharp change in consumption habits can be avoided. 

Improving the competitiveness of companies is the key to faster growth in productivity and the economy. The general indicators for competitiveness have not worsened this year despite the rapid growth in labour costs, which may indicate an improvement in the non-price competitiveness of companies and their products. This is also shown by the better performance of export goods, which contain more value added created in Estonia. Competitiveness may suffer however if for any reason the growth in labour costs is not restrained and companies are unable to use productivity growth to compensate for the rise in production costs.

The additional stimulus from the government may boost the economy for a while, but may equally lead to a reduction in the economy’s competitiveness and capacity for growth over the long term. Growth in the Estonian economy has not been restrained in recent years by a lack of domestic demand, but by weak opportunities for exports. If additional resources are funnelled towards lifting domestic growth which is already growing strongly anyway, it may hinder the normalisation of growth in labour costs and weaken competitiveness. It could also impede changes to make the structure of the economy more export focused and to move workers into branches of the economy that promise more for long-term growth. If the large-scale investments planned by the government are concentrated in the construction sector, there may be a danger that the industry will overheat as it did a decade ago.

The general government budget will probably remain in deficit in the next three years. This forecast uses those political measures of the new government coalition that had been described in sufficient detail at the time the forecast was made that their effect could be incorporated. The revenue and spending measures that are planned but have not been described precisely may leave the nominal deficit larger than is forecast.  

Read also: Estonian Economy and Monetary Policy 4/2016