Tõnu Palm, Luminor Estonia Chief- Economist

Tõnu Palm, Luminor Estonia Chief- Economist

Tõnu Palm, Luminor Estonia Chief- Economist

Key highlights

Estonia’s robust 4% annual growth during the last 3 years supports ongoing income convergence towards euro-area average

Over the last 10 years Estonia has made considerable progress with a transition from a low to middle income country, which is only starting to be reflected in higher credit ratings. With the EU accession and connected labour markets Estonia was lending initially its fair share of the population to the other more advanced European peers. The key factor behind past emigration flows was a significant difference in living standards to start with. There was also a harsh global economic crisis, which followed shortly in 2007-09 lifting the unemployment rate to a staggering 17% mark in 2010.

With above euro-area average growth rates following crisis years there has been a rather notable recovery in income levels vis-à-vis south European countries. There is however a long-road ahead to reach average income levels in Euro area. This would allow a larger pool of EU labour to become more readily available to balance the needs of the labour market.

Overall, the external environment has been over the last years very much favourable for the open Estonian economy as Euro area, the key destination of exports has staged a robust recovery. Increasingly domestic demand led Estonian economy has delivered a decent 4% average real growth rate over the last three years. This cruising speed lifted the small country at the forefront of euro-area’s faster growing economies together with other Baltic countries.

Estonia is becoming increasingly an attractive choice for EU labour

Sustaining long-term income convergence at higher levels is a challenge, which should rest largely on competiveness, innovation and productivity gains. Catching up in income terms is of crucial importance to solve a number of medium-horizon labour market challenges (such as aging) for a faster growing and still catching up economies like Estonia.

Lack of qualified labour is increasingly cited as a key detriment for Estonian companies growth plans. In the late stage of the economic cycle there is more competition for qualified labour globally. Euro area is reaching already a more mature labour market state with unemployment rate (7.8 % in Jan 19) not far from pre-crisis levels. As the result, it is the lack of qualified labour, which is becoming increasingly acute in a number of euro-area economies not least in the more dynamic fields of advanced engineering, ICT or medicine.

As a major milestone Estonia's GDP per capita hit 78.7 percent of EU28 in 2017. This means Estonia is for the first time reaching at par with some of the southern European countries like Portugal, which were far ahead at the point of Estonia’s EU accession back in 2004.

The average monthly wage in Estonia is up no less than 58% since 2011, when the labour market started to recover from the global economic crisis led by new impetus to exports and investments. As the result the average gross wage is up from EUR 830 in 2011 to EUR 1310 (with a median wage at around thousand) along with growing profits in the business sector.

Moreover, the balanced economic recovery has been accompanied with strong private sector savings and conservative balanced budget principles on the government front. The latter should not come as a surprise given the fiscal discipline, which was deeply rooted already since 1992 when Estonia established its national currency. As the result, the Estonian government debt stands today at a rather modest 8% of GDP (86.1% for Euro area in Q3 18) and is expected to fall further.

As the labour market matures and approaches full employment there is always a potential risk of excessive wage growth, which could in the medium term hamper competitiveness. This is by far not the prevailing general macro challenge today with only some sectors facing (temporary) signs of overheating. For example, the construction sector is approaching its capacity limits and is more prone to squeeze of profit margins.

Notable, over the last three years the growth of wages has on average matched the economies’ nominal growth rate (7.5% y/y). As a sign of economic recovery wage growth is picking up also in the stronger performing euro-area countries. Moreover, Estonia’s labour market rules are flexible by European standards and wages have demonstrated downside flexibility in the past should the global economic cycle turn.

Overall, we expect wages to continue evolving broadly in line with economy’s nominal output exerting positive pressure for the industries to undergo the necessary underlying structural adjustments to adopt to the global trends of innovation, new technologies and smart specialization. It is very much the supply side measures such as digitalization, automation and human capital investment ex cetera, which count for the long-term growth in added value.

As a remarkable achievement the still very much half way income convergence has already manifested itself in four consecutive years of population growth. Population decline has now clearly turned to the growth path with remigration flows and attracting foreign labour (including from the EU) to fill the increasing labour demand.

Net migration has contributed positively to population growth in each of the last four years. Namely, migration to Estonia exceeded the outflow by 5.2 and 6.1 thousand people respectively in 2017 and 2018, with a significant annual average 0.45% contribution to population growth. The real figures for foreign labour acquisition are actually higher with difficulties for statistics to account for the increasing use of rental labour (with estimates as high as 20 thousand or 3% of total employed work on a short-term contract basis last year).&

Robust growth of the past three years is expected to gradually fall below the 3 percent mark in 2019

Despite all the macro headwinds and challenges emanating from the external sector including trade tensions and slowing global trade, 2018 was still overall a rather good growth year for Estonia. Estonia's open economy is highly integrated with the economies of the Euro area and the Nordic countries and has developed hand in hand with them, supported by strong labour markets. Economic momentum did only marginally moderate last year from a robust 5% y/y pace in 2017 to 3.9% y/y in 2018.

The Estonian economy continued to exceed expectations also at year end with another over 4% y/y growth sprint in Q4. Despite the slowing momentum in euro-area manufacturing and services the last quarter saw a slight pick-up in Estonia exports and investments. Expectedly strong contribution to growth resulted from consumption, which is a key growth engine for next years.
Estonia's strong GDP growth of 3.9% in 2018 is expected to follow a general moderation trend evident in external markets, and fall below the 3% mark in 2019 with a slower momentum in Euro area and the Nordic countries. Caution is warranted with headwinds continuing in the external environment with global trade uncertainty and U.S. -China trade negotiations in progress.

It is the strong labour market, which is expected to deliver a substantial contribution to Estonia’s growth in 2019 along with modest growth in investments and exports. Global trade uncertainty remains the key risk factor for the future.

Estonia has reached crossroads

Given the heightened general uncertainty and headwinds for global trade it is a fair question to ask if the reforms and economic success of the past years, which has brought us to close to full employment, will take us as swiftly to the next dose of bright future to be shared widely in the society.

Namely, with the ever faster evolving future technological and structural transformations of global nature, there is often not sufficient progress achieved in timely preparation of the labour markets. These factors affecting sustainable economic developments have been raised increasingly at different economic and policy fora (including recently at Davos Economic Forum). There are a number of tough direct questions to be answered how to achieve a more inclusive and sustainable long-term growth after 10 years into recovery. The aim could be to avoid the detrimental labour demand and supply mismatches and to maximise the benefits from future transformations. It is very much the labour market related challenges and lack of investment into human capital and increasingly into healthcare, which are part of the root causes fuelling a recent rise of populism. Estonia’s economic achievements are clearly tied to the strong united Europe and well-functioning and fair global trade rules.

Estonian economy is at crossroads with questions to be answered which type of investments and structural reforms will be most needed to make the next leapfrog to the brighter future? The new global technology race (be it 5G penetration, AI and robotics, big data, genetics, personalized medicine, smart cities etc) are leading to waves of mergers and acquisitions to form new alliances, since the required development and research budgets are often too extensive for even large European players. Global competition is increasing with the rise of Asia (China) as a super economic power.

The business landscape in smaller countries, such as Estonia, is dominated by micro and small enterprises with limited capital and research budgets. Given the constrained investment resources available there are a number of longer horizon questions related to the optimal structure of the economy waiting to be addressed. For example, is there economic sense to specialize on a number of niche higher-performing economic fields to reap the comparative advantage in the field of globalising exports. A number of European economies have defined specialisations and priorities, which are at the prime focus of their national strategic competitiveness agendas. It is clear that the funds for investments are limited and priorities have to be made at the crossroads for the benefit of achieving long-term sustainable and more inclusive growth, which values the environment.

At close to full employment there is a significant increase in the use of foreign labour, which needs to be seamlessly integrated in the Estonian society (requiring substantial investments in Estonian language skills). The potential list of structural challenges to be addressed for further income convergence is long and the related reforms will not likely yield short-term gains. Alternatively, a domestic stimulus, concentrating less on export competitiveness and labour market development, will at current circumstances lead to faster boost to short-term growth, but as well as to excessive inflation, relocation of jobs to the domestic activities ex cetera with overall marginal impact on long-term growth and prosperity.

While the private sector is the key driver of innovation, the state can be the cooperating facilitator of the positive ongoing developments by removing bottlenecks (including overregulation, limited supply of engineers via universities etc). There is an increasing contribution to added value growth from the novel rise of the ICT sector in Estonia, which combined with innovation in the other industry branches, such as manufacturing, can bring about additional boost to per capita added value growth.

With a transition to smart economies there are opportunities to move to less capital intensive and more service-oriented business models, which are scalable to reach a more global customer base. Moreover a well-functioning start-up ecosystem coupled with funding and equity injections to high risk new businesses would open the door for more new vanguard business ideas and models, which can be potentially applied in traditional industries.

To simplify, crossroads means how much of the total available investment resources available will be concentrated on the stimulus of domestic economy (roads, buildings etc) and how much for leveraging the intellectual capital and research intensive areas most relevant for future export revenues. Skype is the perfect example of investments in human capital and innovation. Not to mention the faster growing export revenues from services makes up more than the deficit on the goods balance.

Overall, European economies including Estonia faces increasingly global competitiveness challenges with the speed of global technological and digital transformation under way. Investment to future long-term growth could address notable research, education and smart infrastructure (incl digital economies, smart cities etc). The optimal balance of investments in this case is likely to be tilted towards more human capital investments and less on the traditional heavy infrastructure spending bills to make a transition to a higher income per capita, smart innovative and socially inclusive societies, which take care also of the weakest. A recipe of long-term sustainable inclusive growth is to the large extent the roadmap of structural reforms leading to productivity. Let’s make Estonia better.

Estonia: Macroeconomy indicators

(% annual real changes unless otherwise noted)

  2016 2017 2018 2019F 2020F
Real GDP, % y/y 3,5 4,9 3,9 2,9 2,6
Private consumption 4,4 2,6 4,6 3,9 3,0
Fixed investment 2,9 12,5 3,3 4,0 4,1
Exports 5,2 3,5 4,3 3,0 3,3
Unemployment rate, % 6,8 5,8 5,4 5,9 6,5
Consumer prices, % y/y 0,1 3,4 3,4 2,0 2,3
Gross monthly wages, % y/y 7,4 6,8 7,6 6,2 5,4

Estonia: Macroeconomy indicators

Tõnu Palm, Luminor Estonia Chief- Economist