Tõnu Palm, Luminor Estonia Chief Economist

Tõnu Palm, Luminor Estonia Chief Economist

Tõnu Palm, Luminor Estonia Chief Economist

Key highlights

Strong start of the year followed by gradual moderation of growth ahead

Estonia has undergone a rather decent economic recovery with above 4% annual growth rate maintained consistently since the end of 2016. Following 4.8% GDP expansion last year economic growth started in 2019 on a stronger than expected footing with 5.0% y/y expansion in Q1 receiving support from broad-based growth in the industry, exports and investments. Growth moderated to 3.6% y/y in Q2 with softer contribution from the industry.

Estonian open economy has benefited the most from ongoing recovery in euro area and Nordic countries. Estonia’s nominal goods exports averaged 5% y/y in H1, with confidence and orders pointing to softer growth outlook ahead.

Headwinds are now gathering with global growth environment deteriorating as a result of protracted trade uncertainty

Estonia’s robust growth rates have likely reached the peak ahead of the gradual moderation to follow with the slower growth environment hitting an increasing number of  European economies.  A shift from de-synchronized growth to synchronized moderation of growth is expectedly  proceeding as was our previous call (Luminor  Economic Outlook, 16 Mar 2019) with key risks for the open economies emanating from trade frictions hitting advanced countries.

Estonia has been only marginally impacted by the global trade slowdown so far. This can be attributed to the expansion in stronger performing European markets, above euro-area average robust labour demand and favourable environment for construction and housing investments.

GDP growth is expected to moderate gradually below the 3% mark in 2020  as headwinds increase for the European economies, and energy plus (close to capacity running) construction sector contribution remain tepid next years. Growth remains supported not least by infrastructure spending financed by EU structural funds.

Growth is moderating, but not falling apart in Estonia’s key export markets

There are clearly growing  growth concerns, however we do not assume an outright recession in euro area or other major global advanced countries (the U.S.) as the baseline. The global macro headwinds intensified during the summer months leading to central banks signalling further policy easing to safeguard growth and investments.

It is difficult to underestimate the economic challenges ahead given that global trade was expanding far below the global growth already ahead of the re-escalation in trade tensions between the global super powers, the U.S. and China. Weakening global trade and rising tariff disputes are affecting export-driven economies from Asia (such as South-Korea, Japan, China) to Europe alike.

Given protracted trade uncertainty,  it is unclear how much of the current softness in global trade is temporary (i.e. related to adjustment of supply chains and cyclical demand), and how much  more persistent. The spill-over from industrial weakness to services is still marginal, but remains a rising risk factor going forward.  

IMF and other institutions forecasts point to sluggish, slightly above 3% y/y global growth in 2019 with only marginal improvement thereafter (3.5% y/y in 2020,  IMF WEO Jul 2019) predicating on stabilization in currently stressed emerging market and developing economies, and progress toward resolving trade policy differences.

Weaker export demand outlook

Among the Estonia’s key trade partners, Germany’s economy (with a 6% share in goods exports), has been affected the most among the euro-area countries from the slowdown in global trade with diminishing demand for capital goods (including cars and machinery.

German economy contracted twice during the last four quarter period with second-quarter output damped by trade, with exports falling faster than imports. Private consumption and government spending rose, and investment increased despite a decline in construction, which is likely to resume growth. Quarterly GDP slowdown remained modest (-0.1% q/q in Q2) with persistently weak momentum mainly centred around the manufacturing sector (including the auto and related industries). It remains unclear whether exports and industry will regain the footing before the stronger domestic sector becomes more severely affected.

Estonia’s other key trade partners, the Nordic economies, exhibit a softer growth patch as well, but continue to benefit from strong fundamentals including tight labour markets and healthy public finances. Following a strong recovery,  growth has been moderating during the last quarters notable in Sweden,  and less in Finland. Norway is benefiting from stronger domestic demand, oil-related investments and bolder construction pipeline. Overall, weaker Nordic currencies and lower rates remain a reflection of deteriorating  growth environment and confidence among Estonia’s crucial trade partners.  Overall, growth is moderating, but not falling apart in Estonia’s key export markets supporting modest expansion of export demand from H2 onwards.

Industrial production volumes have been affected the most by global trade softness in euro area including Estonia

Industry and trade remain very much at the epicentre of growth moderation in advanced countries, whereas gradually softening services expansion has continued on the heels of consumer demand and tight labour markets.

Softer growth environment has affected industrial production volumes the most


Source: Bloomberg

June month recorded exceptionally weak industrial production volumes in a number of European countries. Estonian industry experienced first time since the end of 2015 a noticeable monthly drop (-3.2% y/y in June for Estonia compared to -5% y/y for Germany) dragging down H1 expansion to a meagre +1.3% y/y (after 4% y/y in 2018).

The largest exporting manufacturing branch expanded in Estonia at a still healthy pace (4.8% y/y in H1), while the energy and mining branches remained in contraction.  July saw continued weakness with industrial production down over -5% y/y and manufacturing posting soft 2.5% y/y advance. Overall, the soft patch in European industry will likely persist in H2 with escalated trade tensions and uncertainty. 

There is a need to support further income convergence with euro-area average via longer-term growth enhancing reforms

Successful above euro-area average income growth and strong labour demand has made substantial contribution to Estonia’s population growth over the last years by supporting net migration. Moreover, bold income growth (average wages 7.4 y/y in Q2) underpins the current resilience of consumer demand and has facilitated close to double digits household deposit growth rates.

Furthermore, higher income levels have been often cited as one of the factors, which could lead to further increase of  Estonia’s high credit ratings (with AA- senior long-term foreign currency rating by S&P rating agency). The economic fundamentals remain strong with lowest and further falling government debt to GDP (7.9% of GDP end 2018) burden among euro-area peers. 

During the last decade Estonia has clearly made some progress with income convergence towards euro-area average levels, however, the starting point has been exceptionally weak. Namely,  Estonia’s nominal labour costs (including industry, construction and services) per hour have increased from a meagre 19% to 40% of euro-area average during the last 14 years (2004-18).

Estonian labour costs have effectively tripled over this period from EUR 4 to EUR 12 per hour. However, the absolute level remain still modest and compares to ca EUR 31 per hour in euro area,  falling substantially behind Germany  (EUR 35), not to mention the successful Nordic trade partners (Sweden EUR 37, Finland EUR 34 and Norway EUR 50). The income margins vis-à-vis the advanced euro area peers remain too wide, fuelling ongoing emigration of young talents.

Income convergence can be enhanced by structural changes in the economy


Source: Eurostat

During the current good growth years the time is ripe to address some of the supply side reform agendas (notable the labour market, science and technology, digitalisation) to further boost the added value and productivity growth. The latter export-revenue enhancing factors are the prerequisite for long-term convergence of living standards for open economies.

Closing the remaining income gap with euro-area average becomes ever harder at higher income levels. This is calling for innovation, entrepreneurship and productivity boosting structural reforms. 

There are clearly safety margins, but the cost competitiveness is gradually eroding,  requiring export revenue enhancing reforms from the industry and state. Businesses are increasingly investing in efficiency gains and new technologies, but R&D and human capital investments remain still disappointingly modest compared to higher income peers.

In the more dynamic industries,  such as the ICT sector,  labour costs have over the last decade risen from 34% to already 50% of euro-area average level (to EUR 20 per hour) reflecting positive dividends from human capital investment and ongoing digital transformation. No surprise that such fast-growing services sectors,  tapping the limited pool of engineering talents, are among the first to have hit the supply constraints emanating from lack of qualified labour.

Structural reforms could facilitate gradual labour rotation into higher export- revenue generating sectors.  Given the longer-term  income convergence agenda it makes sense to address in the first priority the concerns of higher-wage (and income tax contributing) exporting sectors,  when considering future education reforms and foreign labour regulations.  There are increasing  benefits from the use of foreign qualified labour (potentially attracting the increasing number of foreign students studying at Estonian universities), who need to be seamlessly integrated in the Estonian society. This requires substantially larger investments in Estonian language skills than currently foreseen. 

Estonia, like other European economies will be devising their national reform agendas for 2035. Would be great if the future reforms will re-focus on long-term growth-enhancing reforms and productivity enablers, among which one can list the education reform, innovation agenda and research and development. Smart infrastructure is one potential avenue to exploit further to better connect Estonia to digitalising global peers.  Similarly, European export powerhouse Germany,  is considering  education, digitalisation, infrastructure and technological advance for raising further the growth potential.  

Forthcoming aging of European economies remains another longer-term growth challenge

Besides the current cyclical weakness, there are notable long-term growth challenges related to gradual aging of societies,  which if not addressed in time, can slow productivity and hence income growth. Aging will likely affect Estonia to the same degree as other euro-area peers.

Rising aging-related costs for the society can be partly mitigated by reforms facilitating overall income growth (and hence savings capacity for retirement). Besides the above-mentioned structural reforms rising the share of higher added value generating economic sectors in the economy, there are ample opportunities to enhance the general labour participation rates.  For example, the expected longer participation in the labour markets can be facilitated by novel education and health care reforms.

Euro-area labour markets have already undergone substantial recovery with unemployment rates close to pre-crisis lows and labour participation rates making new record highs. For example, in euro area and Estonia labour participation rates of 73.4%  and 79.1% (for the 15 to 64 years age group) are exceeding  the turn of the century levels by no less than 6 and 9 percentage points.  

In context of global technological transformation labour demand will be undergoing constant structural changes.  As a key  general observation the largest increases in the activity rates for the majority of euro-area countries have been accomplished in the upper secondary and tertiary educational attainments. Whereas activity rates for the less than primary, primary and lower secondary education level have even fallen since Y2K.

The higher education qualifications seem  to facilitate labour market performance leading  not only to higher flexibility (to adopt to changing demand due to technological transformation), but also to longer participation in the labour market. Matching labour supply with evolving demand will be crucial for maximising labour income in the future during the age of digitalisation.

Estonia has maintained a rather stable and high participation rate (88%) for the tertiary education group. Substantial progress  been made actually by raising the participation rate for the middle and lower education attainments (including both primary and lower secondary education, and upper secondary and post-secondary non-tertiary education cohorts). In particular, participation rate in the lagging lower secondary education group is up by no less than 12 percentage points since the year 2000.  Level wise there is now a perfect match with euro-area average.    

The real  potential area for further progress in case of Estonia is related to the still low participation rates for the “elderly”  (defined as people between the ages of 60 and 64).  The “prime-agers” (between the ages of 25 and 54) post already high activity rates by international comparisons.  
 
Remarkably, the activity rate for the elderly  has nearly doubled since the turn of the century. Namely, the participation rate has increased by no less than 27% in euro area  (from 21% in 2000 to 47.9% in Q1 2019), and by 32% in Estonia (to 63.8%).  Raising the retirement  age by substantial degree in the future without sufficient support for labour markets  (including general health improvements etc) would likely backfire, and lead to ultimate costs to growth by raising social spending.

There are still significant divergences among the euro-area countries reflecting partly different economic and labour market structures plus policy frameworks. For example,  the elderly participation rates stretch from as low as 35-37% in Greece and France to close to 75% in Sweden.  Among the key trade partners,  Germany stands at the middle with 62.5% elderly participation rate and Finland posting close to 57% rate.  High income country Luxembourg experiences by far the lowest elderly  activity rate among the euro-area countries of just 22% 

Aging-related costs can be partly offset by raising labour participation rates for the elderly


Source: Eurostat

Whereas elderly participation rates have improved to the substantial degree,  there are potentially further advances to be made for maximising income especially for the more “senior”  age groups  (defined here 65 years and above).  This can be accomplished among other factors by smart savings solutions for retirements, which maximise investment returns, coupled with incentives to stay longer in employment (by facilitating part-time employment). 

The senior age groups are in general not yet affected by the overall trend rise in retirement ages in advanced countries. However, some more ambitious longer-term  labour market reform plans in European countries contemplate already with the long-term rise of retirement ages even to 70 years.  This requires challenging transformation in labour market structures to say the least. 

Via structural reforms Estonia can achieve even higher activity rates for the more senior age groups


Source: Estonian Statistics Office

Estonia is in the middle of devising its 2035 reform agenda to define which kind of a living environment  would the young generations prefer from future. There is a broad range of topics such as green economy, circular economy, digitalisation to environment  protection ex cetera to consider,  which all require future investments resources.  There are always easier alternatives to structural reforms boosting long-term income,  such as to build comfortable roads to spend the limited scarce resources. 

Among the wish list one should not forget as well aging, which is a natural positive ingredient of prosperous European economies.  Aging just calls for enhanced structural reforms to meet the future rising health-care and social expenditure costs. Enhancing elderly participation rates, boosting innovation capacity of the economy and smart saving for retirement remain among the core solutions. By shifting labour demand towards higher education attainments one could already today boost participation rates for the elderly in double digits (minimum by 30 percent).

Thus, with structural shifts towards smart knowledge-based sectors and openness to talents from abroad,  there is further progress to made to the even brighter economic future, in which high productivity levels can be maintained throughout people’s working lives limiting the downward impact that ageing has on future productivity, the key source for prosperity.

Estonia: Macroeconomy indicators