Luminori peaökonomist Tõnu Palm

Luminori peaökonomist Tõnu Palm

Tõnu Palm, Chief Economist of Luminor

IED Highlights

After a close to 5 % y/y boost last year the Estonian economy continues to post above-trend growth, albeit at a slightly slower pace. The slowdown is modest as the domestic sector has shifted into a higher gear while the outlook for exports markets is bright. Investments are finally picking up and are expected to broaden across sectors, with construction being a hot spot. Bottlenecks on labour markets are leading to rising wage demands. Inflation is slowing to ca 3 %. Investments in long-term growth are now needed.

Estonian key macro-economic indicators (% annual real changes unless otherwise noted)

  2015 2016 2017E 2018F 2019F
Real GDP, % y/y 1.7 2.1 4.9 3.5 3.0
Private consumption 4.6 4.4 2.3 4.6 3.4
Fixed investment -3.0 -1.2 13.1 4.5 4.1
Exports -0.7 4.1 2.9 3.1 3.9
Unemployment rate, % 6.2 6.8 5.8 7.2 7.9
Consumer prices, % y/y -0.5 0.1 3.4 3.0 2.7
Gross monthly wages, % y/y 5.9 7.4 6.8 6.1 5.8

Note: E - estimate, F - forecast | Source: Eurostat, Luminor

Above-trend growth moderating

Acceleration of the global economy and synchronised growth across export markets bode well for the growth outlook and confidence of businesses. The latter are finally starting to gear up investments from low levels.

There has been a return of economic confidence to boom-year highs and developments on key export markets – most notably in the Euro area – have fared better than expected. In a positive surprise, growth in the Estonian economy last year reached 4.9 % y/y ( 9% y/y in nominal GDP). The expected broadening of growth was realised, with an initial export boost complemented by investments.

Investment growth broadening

After three years of disappointments, investments were up last year and in a rather bold way. Investments added a significant 3 percentage points to GDP last year, which is three times as much as consumption.

Moreover, the return of demand and pricing power has supported a pick-up in enterprises revenues. Income streams are expected to gain further traction, with an increasing contribution from domestic demand. Growth across industries continues to broaden, with the majority of manufacturing branches delivering growth, which is lifting as well profits. Some of the sectors most affected by the global commodities cycle and sanctions (energy, food processing and transportation) have now staged a comeback.

Construction sector recovers at close to capacity speed

By far the biggest surprise has been the sharp rise in construction activity following subdued and uneven years of growth. The construction volume was up by 22 % y/y on average in 2017 (from a low base) and future demand looks buoyant. Construction turnover (in Estonia and abroad) reached close to the boom years for the first time in Q3 2017 (however, as a percentage of GDP remains much lower)!

Whereas residential construction has gained in volume in recent years rather consistently, there is clearly new impetus for infrastructure and commercial space development. The flow of EU structural funds is gaining traction, complemented by increasing state co-financing. Furthermore, the corporate sector has geared up investments in renovation and structures.

Ongoing modest house price rise benefits the economy

One positive aspect for containing living expenses is the new supply of housing, which has helped to suppress price trends on the housing market. The house price index is expected to gain at moderate pace (ca 5 % y/y in 2018) remaining in line with Euro-area average price trends. More newly built apartments are hitting the market, giving people more choice.

Housing development looks set to slow somewhat going forward as companies increasingly report capacity constraints (capacity utilisation in construction having risen from 84 % to 90 % last year) and developers are sensing demand constraints as prices in city centres have recovered to close to pre-crisis levels. Completions are indicating strong supply, which nevertheless falls short of the boom years. Appetite for mortgages at higher prices has remained rather stable, with lending growth averaging below 7 % y/y. Savings growth still exceeds lending rates.

Apart from the ample supply there are constraints from lower growth in real income. We expect fast wage growth also from next year, with real income growth being limited by gradually abating inflationary pressure.

Overall, there are upside risks to investment growth stemming from activity in construction space. As a positive, corporate investments are expanding in machinery and equipment plus computer systems segment. In the years ahead construction activity will remain rather buoyant with infrastructure spending on the rise and expansion in industrial capacity.

Investments in export performance

Since increasing labour shortages will contain GDP growth, performance in the medium term will rest to a large degree on productivity-boosting measures like investments in human capital and technology. The manufacturing sector has the potential to enhance value added via product sophistication, technological advances and digitalisation. Prioritizing human capital development for the higher value added exporting sectors can constitute as one of the growth-enhancing structural measures. In the coming years, with strong domestic demand, avoiding overreliance on investments into domestic markets would benefit balance growth. The accelerating global economy provides ample opportunities for expansion of exports across markets and exports diversification. In a more technology driven digitalized world, it is the services exports which will increasingly play a dominant role in advanced countries including Estonia. Over the last 5 years services exports in current prices have expanded twice as fast as goods exports.