Tõnu Palm, Chief Economist at Luminor

Tõnu Palm, Chief Economist at Luminor

Tõnu Palm, Chief Economist at Luminor

Main topics

Estonia’s economic growth has been the fastest in the euro area in the last three or five years

The average economic growth of Estonia in the last three years, which is 8.9% in market prices (and the country’s 4.9% real GDP growth), clearly places it among the fastest growing economies in the euro area.

In the last 10 years, the income of the economy has increased nominally by 97%, wage income by 95% and the profit of companies by 133%.

Whilst the share of employees compensation in the economy has remained largely the same (ca 49% of GDP), the share of corporate operating surplus in GDP has recovered from the 19.1% of the economic crisis of 2009 to 22.6%. The profits earned are a vital source of new investments as reinvestments remain high (Estonia has competitive tax framework).

The growth environment of the world economy is deteriorating due to the new coronavirus risk

Although the “phase one” trade agreement between China and the US will have clearly a positive long-term impact for the global economy, the global growth environment is unfortunately deteriorating sharply again due to the new coronavirus outbreak. The risks are medical as well as  economic with possible U-shape recovery depending on the speed of containing the spread of virus in global economy. It is vital to ring-fence deterioration of balance sheets of the most affected. Targeted measures are required at most and we have to avoid excessive credit tightening and credit crunches leading to overreaction and following labour market deterioration.  

China is the most exposed country to the risk today, but the global impact of the virus increases alongside its spread because of global value chains, integrated markets and weakening confidence. A new slowdown of global economy and the decreasing demand for services in addition to already soft demand for capital goods are real new economic risks.

The spread of weakness from the industrial sector, which had barely started stabilising, to the service sector will cool down economies and corporate revenues beyond the first half of the year. The main risks of Estonia are the subdued foreign demand and the uncertainty caused by the coronavirus. Estonia’s main trade partners are the euro area and Nordic countries with strong fundamentals, which may receive support from a more targeted stimulating monetary and fiscal policy mix as risks evolve. The G7 countries have also announced coordinated steps, which emanate from specific local needs, in order to reduce the impact of the virus. Viruses pass.

The coronavirus risk will last for as long as it stops spreading and substantiated information about the effectiveness of vaccines is received

We are in highly uncertain environment with little visibility how deep we dive. The exceptionally fast economic growth in Estonia has passed its peak as expected and will be followed by a considerably more modest development, which is evident in increasingly more European countries.

The real economic growth has remained relatively robust against the background of a more modest price increase.

After the robust 4.8% GDP growth two years ago, Estonia once again surprised with an economic growth of 4.3%, which was somewhat higher than expected. The growth was broad-based and the annual increase in total export accelerated from 4.3% two years ago to 4.9%. Investments increased by 13.1% with the support of the private sector’s property and transport development.

As expected, the economic growth already softened to 3.9% in Q4 due to headwinds from external demand.

The coronavirus risk will evolve as long as its spread slows down noticeable and information about the effect of vaccines is ultimately received

The weakness of global trade alongside the sharp decrease in commodity prices cool the export revenue and Estonia economic confidence. Because of foreign demand, the GDP growth will gradually slow down to close to 0,4% in 2020 with downside risks prevailing short-term. The slowdown comes from a very high base and is temporary in nature with likely strong rebound following next years.

The impact of the coronavirus is keeping the European industry in decline, the energy sector is experiencing a sharp price decrease and the contribution of the Estonian construction sector will also remain modest outside residential space. The increase in the volume of the Estonian manufacturing industry slowed down in 2019 to a soft 2.8% y/y, but a significant annual decline of -1.4% occurred already in Q4 (in comparison with -5.8% y/y in Germany). Global industrial orders and decline in PMIs, lengthening of delivery times etc all suggest that the decline will initially be substantial and given the most recent evidence available on virus impact (for example in aerospace, tourism or energy sector)  the potential weakness will be substantial next quarters as many major countries are affected at the same time.

The significantly higher stability and resilience of the Estonian economy, which manifested itself also in light of the last crisis (such as the debt crisis of 2012), give additional confidence when facing the new risks in the external environment. The economic stability is supported by strong public finances (the public debt is only ca 9% of GDP, which is covered with reserves) as well as by the private sector’s stronger balance sheets (country has been net lender for last 9 years in row) and more diverse export reach on fundamentally stronger markets. It’s exceptional that the current account has stayed stable and on the plus side (1.7% of GDP in 2019) in Estonia even in the recent years of robust growth. It’s impossible to isolate oneself from risks in an open and integrated world, but it is possible to increase resilience including with a strong financial sector. The strong starting point (including a labour market corresponding to full employment) and flexibility of the Estonian economy, which has been repeatedly demonstrated by companies, are helpful as we phase cleary significant challenges ahead.
In addition to the recovery of foreign demand, the pension reform may paradoxically become one of the main accelerators of the economic growth in Estonia as from the end of 2021

On 29 January this year, the Parliament adopted the Mandatory Funded Pension Reform Act, which allows the people an additional option to withdraw their second pension funds if they wish to do so before retirement (whilst paying 20% income tax on the money). Other options are leaving the funds as they are with pension funds or investing the funds themselves (at new separate dedicated savings accounts). There will be more competition which a market economy requires, but what is risky is the choice not to save for retirement. Some countries indeed used during the global crisis and option to withdraw pension money earlier (before retirement age), but this is not the idea behind the reform in this case.  Timewise the reform will likely provide pro-cyclical boost from end of 2021 to the economy, which is already recovering from corona virus soft patch.

If the Pension Reform Act enters into force as it is now, then depending on the economic environment and the preferences of the retirement savers, part of the 5 billion pension savings in the second pillar will mainly find their way to consumption with a likely smaller share being invested. There is a lot of uncertainty about the real impact of the reform on the time scale. However, the impact on the property market will remain secondary, as the average pension savings are rather modest.

All in all, the reform represents a risky economic experiment that will show how responsibly retirement savers will behave after the transition from mandatory to voluntary pension savings. The decisions they make can be significantly influenced by the situation on the financial markets before the reform enters into force.

The reform will also have positive impacts and the share of future withdrawals from funds will show whether or not the improvements came too late. For example, the lower services fees of pension funds, an increased fund selection (with new index funds plus higher risk equity funds added), improved returns and the significant flexibility that the legal amendment will bring about (incl. the vital increased playout options including an option to withdraw all funds in one go at retirement with a possibility to reinvest at own choice will increase significantly competition) – they all have made the second pillar a considerably more attractive savings option. No doubt second pillar has become a much more competitive choice, but would the public acknowledge the recent benefits remains highly uncertain. Whilst promotion of retirement savings may need an additional incentives from the legislator, there is nothing that seems to shake the faith Estonians have in property. Real estate markets have recovered in centres from a sharp drop after the global crisis and are back in big time. 
In the longer term the economy must rely less on volume and relatively more on the price gains of products and services

In a transition to a high-income country like good Nordic peers, the economic growth in the long term must rely less on volume (and less raw materials intensive) and relatively more on the price gains of products and services (more human capital inputs), which calls for the development of value added. Take for example the healthy price of a strong brand like IPhone together with well-functioning services attached relatively to cheap smart phone products also doing a basic job. There will always be customers willing to pay extra for the brand also in the future electric car segments.

In the age of technology, Estonia is facing many structural challenges like other developed countries. In order to prevent the slowdown of long-term growth, Estonia primarily needs to invest in export competitiveness, incl. have the courage to finally define the high-level key focus areas that need to be developed as a priority to gain competitive advantages. 

It’s exceptional that for the first time, ICT plus science and technology branch contributed as much as half of the economic growth in 2019

ICT is already one of the de facto key focus areas of Estonia, but it would be good to see more (personalized medicine, genetics, advanced manufacturing, green economy solutions ex cetera).

In the long term, the rapid development of Estonia’s open economy is primarily associated with the development of the added value of exports, which calls for investments in human capital and smart technologies, and the development of pricier products and services.

The development of Industrial strategy, incl. investments in products/services development and the supporting applied research, require considerably more attention during the age of technology and digitalization.

The rotation from jobs with lower value added towards more advanced positions such as product development and design with engineering content ex cetera that generate higher income and the expansion of businesses to foreign markets (incl. by acquiring foreign companies) are examples of structural measures that are the precondition for income catching up with the average level of the euro area. More Estonian businesses means higher share of owner’s income.

Given the strategic choices of future (including started megatrends like rising climate  protection awareness among the new generations) we have to acknowledge the longer term challenges  already today. As the natural resources are limited, there are no other options to increase income faster in the longer term by focusing increasingly on research and development that leads to the production of smarter branded products and services.

For example, the forest is one of the biggest natural riches that is deeply rooted in the DNA of Estonians. This national wealth must be more carefully preserved by potentially reducing forest cutting volumes, valorising the raw material at home and importing raw materials where possible to meet the rising demand. For example, environmentally sustainable technologies and products will become more increasingly valuable against the background of climate change and gradually rising awareness of the benefits from greener and sustainable development.  With regard to future energy sources (especially in terms of base capacities as well as storing energy from volatile wind and solar), it’s necessary to consider various alternatives that would be relatively more environmentally friendly and cost-effective at the same time. These will be forward looking strategic choices requiring inevitable calculated risk taking.

The new EU Green Deal of the European Commission is very much welcome as there is a need to push market for developing solutions for environmentally sustainable modern economies. Considering  global trends, market participants increasingly acknowledge opportunities of transitioning to the environmentally more sustainable circular economy instead of just threats to existing business models.

For example, investing in the relatively easier solutions such as renovation of housing and more energy efficient dwellings will also help achieve the goals of a greener and more energy efficient economy. Smart cities make use of the opportunities offered by new technologies, the innovative solutions of engineers and big data processing, thereby creating opportunities for increasing the export of Estonian services. Estonia has novel examples of successful specialization (high share of start-ups per capita in global scale).

On the positive side, several environmental issues attracted more attention than ever before at this year’s World Economic Forum in Davos. It seems that the wheels are finally turning, but we don’t really know yet which milestones we are heading or when we will get there. Many solutions related to transition into more climate-neutral economies can only be global to prevent unfair competition, which can turn otherwise good initiatives profitable. With slow global growth outlook there is a real risk that there will be lack of resources to make short term sacrifices to develop the new solutions leading to more words and less real action in terms of climate ambitions.
Property is in high demand in Europe

The weight in total net worth of the aforementioned mandatory savings in the Estonian pension system (the second pillar) is considerably smaller than that of property in the hands of the public. However, the history of mandatory pension savings is also shorter. The true future potential of pre-funded pension systems can be unleashed with time as investment returns have to accumulate over longer time periods  (see accumulation of Netherlands bold pension reserves for example).

Property investments have over the last decade contributed to the net worth of Estonian citizens far more than any other asset class. It has certainly paid off to enhance the real-estate stock in a faster growing economies with lower base rates. However, the financial assets accumulated by Estonian citizens for a rainy day remain far too modest compared to the positively high (ca 80%) property ownership rate. As a potential solution which could add to the economic resilience is gradual diversification of savings away from low yielding deposits (again Scandinavian peers serve as a good example). Globally invested well diversified portfolios of financial assets would help increase the financial strength of people in case of shocks to global trade because of the impact of the coronavirus, which may reach the European labour market to some extent. Obviously having liquidity buffers is even more important in the case of loan burdens.

The property prices in Estonia have increased in the last three years largely in line with the average price trend of the euro area

An adequate supply of property as well as relatively modest demand have helped curb the growth of property prices in a situation where income is increasing fairly rapidly. Furthermore, the use of foreign labour has helped reduce the price pressure in construction. The regulations and administration of the construction market (incl. faster processing of construction permits and projects, ample availability of land in the outskirts of the city etc.) is also crucial to allow developers to respond as timely as possible to changes in demand with an aim to avoid unwarranted excessive price increases.  Financing conditions and the flow of foreign capital to property markets are also important factors behind price trends. Unfortunately, the history teaches that increase in real-estate prices (in particular in major centres) tends to evolve faster than average income growth. These mismatches appear usually in the mature phase of the economic cycle with corrections during downturns. History shows that this cyclicality cannot be ruled out, but prepared for by larger financial asset buffers.

Property prices in Estonia have increased in the last three years largely in line with the average price trend of the euro area (marginally faster).

In the case of Estonia, the Eurostat house price index exceeded the pre-crisis level of 2007 by ca 20 percentage points in Q3 2019 (17 percentage points in the euro area, 18 in Finland, 25 in the UK, 48 in Germany, 53 in Sweden and as much as 60 percentage points in Luxembourg). It’s not extraordinary that property is highly valued today and in other European capitals which have  experienced faster price increases than Estonia.

The square metre prices of new high-quality apartments in the centre of Tallinn (at least 3 thousand euros/m2) are expensive for Estonians, but cheaper in comparison with the price tags of 4 thousand euros in Prague and 10 thousand euros in Stockholm.

The fact that property prices in some country have gone up by 50% in comparison with the period before the economic crisis does not automatically refer to imbalances if the price increase is supported by a sustainable increase in incomes and the economy remains well in balance. As the wage growth moderates in Estonia, the debt to income ratio of private persons may in the future start to gradually converge towards the average of the euro area once again.

In the case of Estonia, the biggest difference in comparison with the pre-boom period is that the lending momentum remains much more contained. The private loan offer reached the record level of 12% of GDP per year in the three years before the 2008 global economic crisis, whereas new lending volumes today are completely of different magnitude (2.4% of GDP).  Household debt to GDP ratio remains comfortable below the euro area average in Estonia, but the different savings capacity must also be taken into account.

All in all, Estonia has benefited from the fact that property comprises by far the largest share of the assets of its residents. The active property market supports the choice of citizens and brings tax income to the state. In comparison with the other countries in the euro area, the price level in Estonia is already high as a ratio to income, which is why an increase in land tax expenses that exceeds the pace of inflation would not be optimal in the future. There is a reason why a cap (ca 650 euros) has been established on land tax in Sweden, where the median wages are three times higher.

An active property market where an adequate supply of properties would restrain the price increase should be preferred to land tax increases that discourage investments. This would also give young families the motivation to save via property and thereby deepen the ties with homeland as emigration of talents will remain a challenge for small countries.