The latest economic forecasts from the Bank of Estonia report that conditions are improving for a recovery in economic growth. GDP will move towards an upward trajectory throughout 2023, but the growth will be built on the back of the downturn that happened in the second half of last year, which means that the economy will still be 0.6% smaller in size for this year overall than it was in 2022. Growth is supposed to strengthen in the years ahead to around 3%. A recovery in foreign markets is the key factor, followed by possibly cheaper energy, slower growth in consumer prices, increased purchasing power for consumers, and improved confidence among companies and households that will make conditions more favorable for investment. Higher interest rates mean that the growth in borrowing and investment will be slower, and consequently, it will offer less support for the economy.

However, there is a lot of uncertainty around the forecast. The uncertainty around supply chains and energy on the one hand, the future course of the war, and geopolitical tensions on the other one.

The downturn in the economy has not yet been accompanied by any major increase in unemployment. Shortages of skilled labor have encouraged employers to retain staff in the expectation of a recovery in demand, and this is demonstrated by employment remaining stable so far. One reason why employment has survived despite the economy cooling is that the sectors hit hardest by the energy crisis are less labor-intensive. However, unemployment will rise after a little delay as a consequence of the recent downturn and will peak at 7.2% this year before starting to fall again.

Inflation of 17.6% in February reflects the leap in prices in the first half of last year, while the cost of the consumer basket has risen by only 1.3% since August 2022. This leads the analysts to asses that inflation may be expected to fall below 10% by the middle of the year and to be around 4% by the end of 2023. Yet, inflation passing through into wages and collective wage agreements will keep wages growing fast this year. Public sector wages will rise by around 16% in 2023, while pressure on private sector wages will come from rises in the minimum wage and the cost of living. Rising wages in sectors focused on the domestic market could make exporting companies less competitive even though the local level of wages in manufacturing will still remain far below those in the Nordic countries and Western Europe.

Hence, further growth in the economy will depend on international competitiveness. And corporate estimates of international competitiveness have fallen to low levels.

Higher energy prices have affected the performance of Estonian exporters more than they affected businesses in other European Union countries on average. The Estonian economy is very energy intensive and so higher prices for fuels have a broader impact and affect the competitiveness of the whole economy. Estonia is one of the countries where the support measures for businesses taken to ease the impact of the energy crisis were modest, even though the rise in the producer prices of domestic energy producers and in the consumer prices of electricity, gas, and other fuels started notably earlier in Estonia than in other European Union countries, and was notably larger.

Exporters may also be even less competitive if the general government budget deficit rises because of the financial stimulus given to companies oriented to the domestic market, putting additional upward pressure on prices and wages. The budget deficit will increase by 1.5 billion euros this year to 3.8% of GDP. Growth in general government expenses will be driven further by increases in the public sector payroll and in investment at a time when the growth in state revenues is slowing. It will be pushed up by a sharp rise in child and family benefits, and by indexing of pensions and a one-off additional rise in them.

The latest Competitiveness Report concludes that the key factor in keeping the Estonian economy on its path of growth is the competitiveness of Estonian companies in the global markets. Estonia’s market share increased substantially as the pandemic ended, but the growth in the market share of Estonian exports stopped last year. This caused a general rise in prices and costs throughout the economy. Estonian exporters were less able last year to set their sales prices, and uncertainty and a lack of demand meant that companies could not pass the higher prices for commodities on into the end prices of their products. This was expressed in weaker exports of goods last year.

Deputy Governor of Eesti Pank Ülo Kaasik said that strong growth in the debt would make the state less able to help the economy if it faced a new crisis, and would add further domestic price pressure onto inflation that is already high.

“The Estonian debt is not large, but the revenues and expenditures of the state are systemically out of balance. Fiscal discipline must be restored in order to slow the growth in the state debt”, he told a discussion panel on state finances as the foundation of financial security. This would cause two kinds of problems. The short-term problem is that a state budget deficit of that size will increase domestic price pressures at a time when inflation is already very high. The second problem is that maintaining such large deficits will cause the state debt to increase.

The capacity to borrow is one of the most important buffers that the state finances have if they are to be ready to face any crisis. Estonia would benefit in the longer term if the financing of the economy become less bank-centric and more diversified. This would require rapid development in the non-bank financial sector and an increase in the share of financing by bond markets. “The current plans would require the Estonian state to borrow substantially, so we could consider promoting a local bond market where Estonian sovereign bonds could be issued on the Estonian market”, Mr. Kaasik said, noting that this would also incentivize the development of the private sector bond market. Competition between banks has increased in Estonia in recent years, though there remained room for improvement.