The climate for growth in the Estonian economy continued to improve at the start of the year. The impact of the new energy crisis is not yet reflected in the figures for economic activity, but various indicators show that the Estonian economy was clearly reviving before the war in the Middle East started. Corporate expectations for output and employment in the main sectors of construction, services, retail and manufacturing were rising until the start of March, reflecting increasing belief in future growth. Sales volumes for goods have increased in the past two years in both domestic and foreign markets, and exporters assess that they became considerably more competitive at the end of last year. Improvements in exports of goods, and especially the manufacturing sector that is the backbone for them, played a large role in the exit from earlier crises.

The outlook for the global, European and Estonian economies depends very much on how the war in the Middle East and the energy crisis it has caused play out. Prices for fuels rose after the attacks on Iran, and that then pushed up prices for other important commodities and also the forecasts for those prices. Futures transactions and interest rates rose in money markets in the expectation of higher inflation. Eesti Pank was forecasting economic growth of 3.6% this year in December, but the energy shock means that markets now expect inflation to be higher, and consequently interest rates too. Higher inflation and the consequent slower increase in purchasing power together with the increased uncertainty caused by the energy shock mean the forecast for growth in the Estonian economy this year is reduced to 2.8%. Events in the energy market impact the economy but are hard to forecast for geopolitical reasons, making it probable that the actual performance of the economy will be different to the current forecast for prices and economic growth.

Growth in the economy will be led by domestic demand this year, as consumer spending and investment will both increase. The largest increase in investment will be in investment by the state in national defence, which will largely go on imported goods. The money spent on those imports will consequently leave Estonia and will not contribute directly to growth in the country. The change to the Income Tax Act will however give a strong lift to people’s purchasing power and their capacity to consume. The average gross monthly wage will rise by around 6% this year, but the growth in the average net wage will be much larger at around 10% because of the fall in the effective tax rate. This means that real incomes will still increase substantially despite prices rising, and that will then encourage private consumption and so the economy as a whole.

The war in the Middle East making energy more expensive and the indirect impact from it will keep inflation higher than it would otherwise have been. The oil price has bounced up and down since the start of the conflict and the uncertainty about what is happening in the energy market is a major source of forecast errors, because changes in the oil price pass through into the prices of other goods and services. The data available confirm that the rise in the oil price has passed through into gas and electricity prices less powerfully than the energy crisis and price spikes of 2022 did, because European countries have reoriented towards new suppliers. This will reduce the impact on the whole consumer basket of oil becoming more expensive. Future transactions in the oil market indicated at the time the forecast was written that markets expect the oil price to fall in the second half of the year. If the markets are right, inflation in Estonia will be 3.8% in 2026 and a little above 2% in the next two years.

The budget deficit and the state debt will increase, and that will raise the annual interest expenses of the state. The increase in defence spending to above 5% of GDP and the drop in revenues following the changes to the Income Tax Act will be the main causes of an increase in the general government budget deficit this year to 4.4% of GDP. If the government and the Riigikogu do not change direction, the deficit will be of a similar size in the next two years as well. The Estonian state debt remains small in international comparison, but the continuing rapid growth in it is a cause for concern. The long-term security outlook for Estonia, the demographic situation, and the increasing cost of interest payments make it important to think about how the state finances can be brought back to a path of long-term sustainability and how the growth in the debt burden can be arrested. The large and constant deficit in the state budget calls for new decisions to be taken that will bring the budget closer to balance, not further from it. It is also important for tax policy decisions to be carefully considered, clearly explained in good time, lasting, and supportive of growth in the economy.

Additional information:
Viljar Rääsk
Head of Communications
Eesti Pank
6680 745, 5275 055
Email: [email protected]
Press enquiries: [email protected]