The Estonian economy is recovering from its recession and Eesti Pank forecasts that it will grow by around 2.5% this year and in the next two years. Maintaining growth in the economy in the coming years will need productivity to be increased, which will need more investment and broader use of technology. The main risk to the forecast is that inflation could rise if energy prices do not come down from their current high levels. The long-term problem for the Estonian economy though is the rapid growth in the national debt.

Several factors are supporting growth in the economy. The introduction from this year of a uniform basic tax allowance for everybody has increased incomes and private consumption, and growth has also been boosted by the increased spending by the general government financed by government borrowing. Foreign markets have become more favourable for Estonia at the same time, and that has supported exports from the manufacturing sector. Export markets have become more diverse in recent years and this is starting to pay off. Increased investment around the world in artificial intelligence has also supported exports by reviving international trade.

Some of the current growth comes however from the recovery in the economy. The growth so far has largely been achieved by bringing production capacity that had been left idle during the recession back into use. Capacity utilisation in industry has reached a similar level to where it was in the years when the economy was growing stably. Efforts were made to avoid redundancies during the recession, which may have resulted in work intensity being lower, but the recovery in a lot of branches of the economy now means that labour is being utilised with the same intensity as it was before the recession.

Further growth will consequently depend increasingly on productivity being raised, as there is less spare capacity in the economy to support further growth. Increasing productivity will need new investment, wider use of technology, and a labour force with the appropriate skills. Economic policy should consequently focus more and more on improving productivity and competitiveness.

The risk of inflation rising casts a shadow over the outlook for economic growth. Inflation has come down over the past year, but price pressures have started to strengthen again. Rising prices in global markets for natural gas and fuels are already pushing inflation up, and are passing through directly into energy and transport costs and indirectly into the prices of many other goods and services. The fall in inflation may consequently prove temporary, and sentiment among companies and consumers will again be affected by energy prices and the geopolitical context. Central banks will raise policy interest rates to restrain high inflation, and this will then restrict investment and spending by companies and households.

One of the main problems for the Estonian economy remains the large budget deficit. If the government does not take additional steps to reduce the deficit, it is forecast to exceed 2.2 billion euros in the years ahead. The budget deficit is larger than was earlier forecast as wages and private consumption have grown more slowly than was expected, and so tax revenues have also grown more slowly. A large deficit over the long term is a serious problem as interest expenses increase each year together with the debt. It is forecast that the state will be paying 472 million euros in interest in 2028 and that that amount will increase further in subsequent years. A rapidly increasing debt and a large budget deficit will make the state finances more vulnerable and will make it harder for the government to react the next time there is a recession

The longer decisions about reducing the deficit are delayed, the larger will be the spending cuts and tax rises that will eventually be needed. It would help solve the problem of the rapid growth in the state debt if the political parties could agree on a level at which it would be reasonable to maintain the Estonian debt and on how quickly the state budget deficit should be reduced. Eesti Pank recommends that Estonia’s domestic fiscal rules should be used as a starting point. This would mean reducing the budget deficit by 0.5% of GDP a year and would help maintain the general government debt at around 30% of GDP over the longer term.

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