What makes space for Estonian economy recovery?

 

The article discusses Estonia's economic prospects and growth potential, especially in the long term after the recent economic downturn. The article asks how quickly the Estonian economy could recover, particularly considering the potential non-recovery of the logistics and transit sector to its previous level.

Experts from the Ministry of Finance warned in the autumn that Estonia's long-term potential economic growth may have slowed down by half. While before the coronavirus crisis, about 3% economic growth was considered normal, current estimates put the potential growth for the coming years in the range of 1-2%. This is reduced due to the expected low contribution of total factor productivity.

The economy's growth potential is difficult to measure precisely, but the emergence of such a trend is worrying for several important reasons. Firstly, it shows whether and how quickly Estonia will catch up with Central European countries from its current level. Luminor analyst Lenno Uusküla notes that if the expected economic growth of the European Union remains around 2%, then it will probably be lower for richer countries. According to him, in this view, Estonia is approaching old Europe even with a 2% growth rate, although this may be too slow.

If the economy grows by an average of 2% per year, it will double in 36 years, but with a 3% growth, in 24 years. Secondly, growth potential is measured because it is the axis around which the economic cycle revolves, through which it is possible to understand whether further acceleration of economic growth will come at the cost of overheating and inflation. It also helps to assess whether the budget deficit is currently sufficient to promote the economy or already excessive. According to Uusküla, the realization of the announced low growth potential would mean that ordinary fiscal policy simply would not work.

Swedbank analyst Tõnu Mertsina explains that if the actual economic growth significantly exceeds the potential growth, then the economy will start to overheat and price pressures will increase. According to him, companies need to invest in increasing productivity and improving production efficiency to maintain or increase growth potential in the face of a shrinking labor supply.

Calculating the economy's growth potential is complex; the methodology used in Europe is long and technical. Essentially, economic growth is divided into components (labor, capital or investments, and productivity), and trends are projected. Erki Lõhmuste, a representative of the Ministry of Finance, gives an example that if Estonia's actual average economic growth over the last 20 years has been 2.8%, then the complex methodology mentioned above gives a very similar average growth potential for the same period (3%). Growth potential is a real indicator, unlike GDP at current prices, which can increase due to price increases even if the volume of production does not grow.

Several factors are slowing down Estonia's economic growth potential. Simple sources of growth have been exhausted. The contribution of labor has been strong, employment is high, and unemployment is manageable, which means that labor can no longer grow the economy at the same pace. In addition, the population is aging both in Estonia and elsewhere in Europe. The situation regarding investments is not bad; Estonian business sector investments as a percentage of GDP have been higher than in Latvia, Lithuania, and the euro area on average. A Swedbank survey shows that companies are focusing on improving efficiency.

The main concern is productivity and the fact that the long economic downturn is not recovering at the expected rate. Some things, such as east-west transit, may not recover in their previous form. The recession in the Finnish and Swedish construction and real estate markets is hindering the Estonian construction and industrial sectors. The price increase has been passed on to consumers, but this has reduced sales volumes.

According to Lõhmuste, there is still room to restore three percent growth through the equalization of economic levels, or convergence, as the Nordic countries are still significantly richer. Since it is difficult to employ more labor, the focus must be on investments and productivity.

Lõhmuste hopes that actual growth may turn out better than current expectations indicate. Commercial banks' analysts find that the growth potential figure may be low at present because employees are underutilized in companies: the volume of production has decreased, but the number of employees has not. This may be due to the desire to be ready to increase production when demand recovers.

Uusküla does not believe that Russia's aggression has changed the long-term economic growth potential. According to him, about a year's worth of growth was lost due to the decrease in Russia-bound trade, but its impact should not be more than a percentage point, as shown by a comparison with Latvia and Lithuania. Higher interest rates and geopolitics may have also affected investments in 2023, which is why potential growth may have been lower.

According to Uusküla, there is plenty of room for recovery right now; GDP per capita is up to 15% lower than it would have been with normal growth. This means that the economy has been below its potential for a significantly long period. Achieving the previous level should be quick if conditions improve. Mertsina suggests that with increasing demand, companies' productivity will also improve along with the growth in output.

Although the share of services in the Estonian economy is increasing, especially in exports, the export of goods (industry, agriculture, and forestry) is still significantly larger in relation to GDP. The balance of trade in services is strongly positive, while the balance of trade in goods is negative. With an increase in foreign demand, the foreign trade balance of goods and services should become positive, which would support economic growth.

The performance of the German economy is important, as it significantly affects demand in both the euro area and countries important for Estonia, such as Sweden. Problems in the German automotive industry could lead to an increase in unemployment. Germany's economic success has so far relied on a strong industry and cheap Russian energy, which supported exports to China. German analysts no longer believe in the recovery of economic growth to pre-pandemic levels due to structural problems such as the abandonment of fossil fuels, digitalization, demographic changes, and international competition. Recovery will primarily be supported by domestic consumption.