Tõnu Palm, Luminor Estonia Chief Economist

Tõnu Palm, Luminor Estonia Chief Economist

Key highlights

Welfare growth is reflected by the reversal of the population decline to the soft growth path

If we were to refer to the most positive economic metric recently in a country like Estonia with a small 1.3 mln population size, this is definitely not the 5% GDP growth of the previous year, but the increase in the population that has lasted three years in a row. As already indicated by the moderation in the growth pace in Q1 (to +3.6% y/y, GDP in Q1 18), the extraordinarily robust growth in the previous year was, as expected, to a great extent temporary in nature and does not adequately reflect the increase in the citizens' standard of living. Whereas, population growth that has lasted for three years is a much more comprehensive assessment on the general quality of the living environment, whereof only a part can be attributed to strong economic growth. Population growth influences positively investment climate, as the workforce is taken into account while making investment decisions.  

Increase in population has been supported by net migration

Turning the decline of population to moderate stable growth is a big challenge for many small countries, incl. those in the Baltic Sea region. If we compare Estonia with our successful Nordic neighbour, i.e. Finland, in the last ten years, Estonia's population has decreased by 1.9%, whereas Finland has recorded significant growth of 4.5% (in the euro area, 3.5%). The slowdown of the decrease in population and even its reversal to a slight growth trajectory in the last three years is a significant achievement for Estonia.

Population growth is positive for Estonia’s investment climate. By today, Estonia has recorded for three years in a row a positive net migration balance, whereas in 2017, the crude rate of net migration, i.e. +4.0 (net migration per thousand citizens, annual average), exceeded surprisingly both the euro area average and Finland's figure (+2.8 and +2.4, respectively).

In 2017, migration to Estonia exceeded the outflow by 5.2 thousand people (contributing by 0.4% to the population growth). Whereas, differently from the previous years, net migration also grew from countries with a higher standard of living (from the EU, incl. Finland and the UK). Migration of people with EU or Estonian citizenship increased year-over-year significantly, i.e. by 30% and 20%.

Although the migration statistics may contain inaccuracies and the short history does not allow for making far-reaching conclusions, a number of demographic trends supported by high labour demand and higher than expected wage growth still reflect an improvement. It is remarkable that in the previous year, the annual growth of 0.3% in the Estonian population exceeded for the first time both the euro area average as well as Finland's growth (both 0.2% y/y).

There is no doubt that the future challenges in the area of demographics will not be limited by these first above signs of success. In particular, the unemployment figures have already decreased to a lower level than before the crisis in a number of developed countries, which refers to increasingly growing competition for qualified labour further on. Estonia's average gross salary (EUR 1,242 in Q1 18) remains 2-3 times lower than the level recorded for the major trading partners, therefore causing pressure for emigration.

Estonia's open economy is highly integrated with the euro area and Nordic countries

In the first half of this year, the growth in the global economy continued to be brisk, but less synchronised within different countries. In addition, risks related to global trade softened the otherwise bright growth prospects for the manufacturing sector open to exports to a certain extent (in particular in Europe, as well as in the emerging markets). Estonia's manufacturing export orders are lower than at the beginning of the year, whereas export volumes will continue at moderate pace (with strong contribution from energy products). Faster growth has proceeded in the export of services, supported not least by the robustly expanding ICT sector.

Although a moderation of the strong positive momentum in Estonia's main export market, i.e. the euro area, in the first half of the year was to a large extent expected, the results for Q2 remained slightly below expectations. In particular, the euro area GDP growth trended from 2.5% y/y (0.4% q/q) in Q1 to 2.2% y/y (0.4% q/q) in Q2, with likely softer contribution from exports. In a forward-looking perspective, the continued positive economic climate in the euro area is supported by strong domestic demand, slow tightening of economy's favourable financing conditions and stable labour demand.

Estonia's strong GDP growth of 3,5% in 2018 is expected further on to slow down at a moderate pace, supported mainly by domestic demand, as well as by continued export demand. As regards major risks, the danger of trade barriers having an impact on global trade and the uncertainty of the external environment has still grown. At the same time, we do not foresee that rising trade tensions will translate to a broad-based trade war causing harm to the global economy, involving also the European Union.

The performance of the three major trading partners – Finland, Sweden and Germany, which represented 18.5%, 17% and 7.8%, respectively, of direct exports of goods (except re-export) in the last year – will play a major role for Estonia's external demand.

As far as the share of (direct) exports to the US is only 3%, in the case of the escalation of the trade tensions between the EU and the US, indirect impacts would be more important than direct factors. Another potential global risk in markets is the rise of dollar rates which together with trade tensions could exert pressure on the Emerging market economies. The share of the latter in Estonia's export still remains modest. Russia is only 11th trade partner with regard to direct export volumes (share of 2.5%).

As regards future investments, sectors with a faster growth in added value should be preferred

Economic growth will to the greater extent depend on investments in productivity, since an increase in employment will be contained and a more moderate growth pace is also expected in the external markets.

In order to support the growth-enhancing structural changes in the economy, priority should be given to the development of knowledge-based exporting economic sectors (incl. ICT) with a high growth in added value, which are capable of creating higher paid jobs.

To achieve the convergence of the standard of living of citizens with the euro area average, the knowledge-based economy requires new investments in the export potential, in the creation of new higher paid jobs (which presumes foreign investments) and in the business and living environments.

According to the experience of Denmark as an open economy with one of the highest standards of living, in particular, the industrial and services sectors oriented towards exports have been best capable of demonstrating a relatively faster increase in productivity. Moreover during the post-crisis period it is the larger companies which have contributed the most to new growth with their investments.

With regard to Estonia, in the last ten years the major sectors with the fastest increase in added value have been the ICT sector; professional, scientific and technological activities, and the energy sector (exceeding respectively 10, 5 and 4 times the growth pace of added value in the economy). Digitalisation and new technologies create new business models, which constitute a significant source for raising productivity in the future.

Estonia: Macroeconomy indicators
(% annual real changes unless otherwise noted)

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

Detailed forecast table