Analytics, Banks, Economics, Estonia, GDP, Labour-market

GDP growth in Estonia rose to 4.4% in the first quarter of the year, which is the fastest rate since 2012. Growth in the economy has stepped up sharply thanks to increased foreign demand, while problems in some individual sectors have also been alleviated. Growth was restricted in previous years by the Russian sanctions and a fall in Russian demand, which particularly affected the transport sector, agriculture and food processing. The low oil price caused problems for oil shale processing, while energy production has been volatile. Output has now increased again in most of these sectors, and made a positive contribution to economic growth. Alongside the exporting sector, areas of activity focusing on the domestic market have also done well thanks to rapidly rising demand. Strong figures for trade and construction volumes that are up one fifth on a year earlier and are approaching their peaks of a decade ago indicate a very strong growth cycle.

Increased demand has lifted the economy above its sustainable level. Growth in the economy was slow for the past four years, but the lack of investment has meant that potential growth was also low and the economy was running at close to its potential. The result of growth at the end of last year and in the first quarter of this has been that the output gap has turned positive, meaning that actual GDP growth has exceeded long-term potential growth. Other cyclical indicators mark stronger economic conditions, as the capacity utilisation rate, corporate confidence and household confidence are above their earlier averages, and order volumes for production and exports suggest that the upswing of growth will continue for the time being.

The cyclical upswing is particularly noticeable in the labour market. Unemployment has for years been so low that there has been excessive upwards pressure on wages and labour costs have risen faster than labour productivity. Companies find that labour shortages are already restricting production more firmly than in the past decade, and there is no sign of this easing in the near future. In future economic growth will have to be based on productivity growth alone, as the amount of labour is a limited resource that changes only very slowly. The economy can only grow by leaning on employment growth if the economic cycle has been in a recession and people are moving back from unemployment into employment.

Although labour force is limited for the economy as a whole, the amount of labour available at company level depends on each company’s advantages over its competitors, which are dictated by investment in productivity growth and the resulting wage level. Competition between companies has already led employees to change employer more frequently and when the movement is from companies with low value added to areas with higher value added, the limits on labour have a stimulating effect on economic growth. If the exchange of jobs is dominated by companies wanting to take temporary advantage over competitors in a wage race however, it is not impossible that the labour market will overheat and the economy will suffer a hit.

Growth in investment gives grounds to hope that productivity is making an increasing contribution to GDP growth and the potential for growth in the economy is increasing. Despite easy access to bank loans, low interest rates, and the existence of companies’ own funds needed for investment, investment by companies has fallen in the past four years. This is partly because of difficulties in individual sectors and the ending of earlier large-scale projects, but in the years of high unemployment companies were able to expand production by hiring extra staff, which was the optimal choice in many cases because of uncertainty about external demand. Increased investment at the start of this year may mark a turning point when economic growth based on hiring more employees is replaced by productivity-based growth. Other possible routes for raising productivity alongside investment are the average number of hours worked per employee, which has not yet fully returned to the level seen before the crisis, effective use of working time, digitalisation of processes, and more intensive utilisation of production resources.

The low interest rates of the single monetary policy of the euro area[1] will encourage growth in the economies of member states in the years ahead, and an economy already facing strong growth does not need additional support from fiscal policy. The government programme foresees a deterioration of the fiscal position and additional injection of funds into the economy. Although the Estonian national debt is small and the rules of the pan-European Growth and Stability Pact allow a structural deficit to be used to fund general government spending, there are problems in this. Large public sector investments in construction could cause a construction sector that is already growing strongly to overheat and could hinder a realignment in the economy to relocate labour to more productive companies and sectors in particular. At the current point of the economic cycle attention should be focused on helping long-term growth, not on amplifying the cycle. It is good to plan government construction projects for times when demand for construction from the private sector is low.

An economy that is small and open to the impact of external events has greater need of a strong fiscal position, which includes having sufficient reserves. Both the Estonian and the European economies have recently achieved faster growth, but this could easily be changed. Were an economic shock to occur, it could be difficult or very expensive for Estonia to borrow, and if there are no reserves there are fewer ways to stabilise the economy. The Eesti Pank forecast finds that the budget will remain in deficit for the next two years, with the structural deficit running at 1.1%. This means the structural deficit is deepening at a time when rapid growth in wages and consumption are causing tax revenues to exceed their long term trends. If the economy then starts to cool again, there is a danger that the government would have to cut spending growth or take additional measures to increase revenues in order to balance the budget. This would worsen the confidence for companies and households that has already been caused by the frequent changes in the law and drafts for more changes.