• Growth has been satisfactory in the Estonian economy given the difficulties in several of Estonia’s main export markets
• Growth is accelerating to between 3% and 4%, which is the current growth potential
• Stresses have not increased in the labour market, but falling company profits are a warning sign

Growth is speeding up in Estonia, but it remains slower than before the crisis, and growth of 2.2% this year is about the same as last year. It will be 3–4% in the next two years, which is the same as the long-term growth capacity of Estonia. Faster growth is restricted by the decline in population, and by the current structure of production, equipment and production technology, which are more complex and costly to add to than was the case before. Without structural reforms to support growth, it could only exceed 4% temporarily, and probably at the cost of the economy overheating.

As several key markets for exports from Estonia are facing difficulties, the growth in the Estonian economy last year can be seen as satisfactory. The outlook for economic growth in the years ahead has not changed much since the December forecast as the exporting sector has so far proved able to cope successfully with the difficulties it has faced. Although exports to Russia have more than halved and the negative impact from Russia is also felt in the Estonian economy through other trading partners, export volumes have still increased.

The fall in Russia’s share of foreign trade has been offset by an increase in the share of Sweden and the euro area, and this change will benefit Estonia in the near term. Growth in the euro area has been rejuvenated by the weak euro, improved competitiveness, lower unemployment, expansive monetary policy, lower credit barriers, and a reduced need to consolidate public sector budgets.

Economic growth in Estonia has been aided above all in recent years by strong domestic consumption. Consumption has primarily increased because household incomes have risen, as both employment and average wages have climbed faster than increased output from companies might have indicated. Despite the strong growth in wage costs, companies generally find that their competitiveness in the European Union market has improved, which suggests that non-price competitiveness has improved and Estonia’s advantage as a producer lies in more than cheap labour resources.

Rising employment and an unchanged vacancy rate indicate that the pressure for wage rises has not increased. The unemployment rate has fallen to the level it was at during the boom and the number of long-term unemployed has also fallen. The number employed will fall next year, but from 2017 it will shrink more slowly than the working age population because of the work capacity reform that will come into force in 2016. Many of those who will be entering the labour market because of the reform do not have appropriate skills or knowledge, so the unemployment rate will rise as a consequence of the reform.

The fall in corporate profits points to the risk that investment and a building up of the economy’s capacity for growth could become more complicated. This could happen if the fall in profits that happened last year were to continue for a longer time. Corporate profits can mainly be increased by a rise in productivity, which would require investments in efficiency and product development. Investment in more efficient production is also vital because of the decline in the population of working age. Credit conditions continue to favour financing for investment and further growth in it.

The fall in consumer prices that started last year has benefited Estonia. The fall in the price of energy sources has had a positive effect, as Estonia imports more fuel than it exports. Cheaper energy has benefited the Estonian economy more than others because it uses relatively more energy than other countries.

Inflation will pick up in the second half of this year, as prices will start to rise for food and energy. Prices will be lifted further in the next two years by the planned rise in consumption taxes. On top of the rise in the prices of domestic production, which is being driven by wage rises, the depreciation of the euro has led prices of imported products to start rising faster.

The Estonian government’s fiscal policy needs to be sustainable to provide stability for a small and open economy that is exposed to risks from the external environment. The government can only act countercyclically and mitigate the negative effects of risks if there is sufficient fiscal space. The new government that took office in the spring confirmed in its budget strategy that is determined to keep the budget in balance over the medium term. The Eesti Pank forecast finds that it is possible for balance to be achieved in broad terms. The budget will remain slightly in structural deficit throughout the forecast horizon because planned social benefits and investment will lift spending above the long-term balanced level of revenues. The new coalition has continued with the strategic goal of shifting the tax burden from labour to consumption. It is important to make sure that sharp or unexpected tax changes do not increase uncertainty among consumers or companies.

Economic growth will accelerate slightly in the coming years, and the risks surrounding it are more likely to reduce growth. The main risks to the outlook for growth come again from the external environment, such as trade restrictions and continuing geopolitical tensions between Russia and the European Union, or the recovery of the global economy and the increasing role played by emerging economies in the rate of it. The large volume of investment in the economy is exposed to the risk that the ability of the banks to get funding could suffer if asset prices in the Nordic countries were to start to fall.