OREANDA-NEWS. December 18, 2013. Estonia’s economic growth continued to be based on domestic demand in 2013 and this was primarily driven by higher household incomes and consumption.

The support for the Estonian economy from exports has been less than was earlier forecast because growth in Estonia's main trading partners was weaker than expected in the first half of the year. The consequence was that the Estonian economy declined in the first half of 2013. Although growth recovered in the third quarter, growth for the full year will be a modest 1%. Estonian economic growth will accelerate as export markets recover, reaching 2.6% in 2014 and 3.9% in 2015.

The euro area economy has recovered at the expected speed and the economic decline that had lasted for six consecutive quarters came to an end in the second quarter. The joint forecast produced by the central banks of the euro area sees that the euro area economy should grow by 1.1% in 2014 and 1.5% in 2015. Inflation in the euro area will stay at 1.4% this year and will slow to 1.1% next year as domestic demand is weak, food commodity prices are falling, and energy price rises will be small as the oil price falls. It is expected that euro area inflation will pick up to 1.3% in 2015. Limited price pressures mean that financial markets expect interest rates to remain very low throughout the forecast horizon. The Governing Council of the European Central Bank has equally confirmed that its monetary policy interest rates will remain low for an extended time.

Interest rates have stayed low in the Estonian lending market and access to bank loans has been good but despite this, growth in fixed capital formation came to a stop in 2013. The main reason was that companies had little need for investment as their existing production resources have been underused. The recovery in export markets should encourage companies to invest in increasing their fixed assets. Increased production capital and an improved supply of capital to labour will allow competitiveness to be maintained and will raise production levels even as the working age population is shrinking and labour costs are rising rapidly. Low levels of investment activity will threaten both the development prospects for companies and the sustainability of economic growth.

Employment increased rapidly in the first half of 2013, but the growth levelled off in the third quarter. A small but constant fall in employment is expected in the coming years. Employment is mainly falling due to the ageing of the population and emigration, and therefore unemployment will similarly fall in the next few years. Unemployment will fall slowly because the current workforce can be employed more intensively through increases to the working hours that were cut after the crisis.

Higher productivity of employees, rises in the minimum wage and an increased public sector payroll will keep growth in household incomes strong in the years to come. The rapid rise in incomes will improve the real purchasing power of households, but combined with consistently low interest rates it could push real estate prices to rise too fast.

Estonian companies have thus far managed to cover their rapidly rising wage costs with price rises, but this is mainly the case for businesses that are focused on the domestic market. Those that are exposed to foreign competition have not been able to raise prices to the same extent. In the economy as a whole, wage growth has outstripped the growth in labour productivity, but wage growth and productivity growth are forecast to come more into line as economic activity recovers. If economic growth remains weak, it will be exporting companies that will primarily find it hard to maintain profitability in the face of rapid and constant wage rises, and this could lead them to reduce their numbers of employees.

Consumer price growth will remain moderate in Estonia in the coming years, reaching 2.1% in 2014 and 2.9% in 2015. Prices will rise more slowly than in previous years, partly because the impact of the sharp rise in electricity prices on the consumer basket will pass out from the comparison base at the start of 2014. Price pressures will also be reduced by a fall in the price of oil. The prices of imported goods will start to rise gradually as the euro area economy recovers. Core inflation will increase at the same time, driven by domestic factors, principally wage rises. The risks to prices are more on the upside because a recovery in global economic growth that is faster than expected could lead demand for commodities, including oil, to push prices higher.

The fiscal position of the general government will remain strong in the next few years. Spending under the budget will still exceed income throughout the forecast horizon. The structural fiscal position with cyclical effects stripped out will remain in surplus throughout the years covered by the forecast, but the surplus will shrink. The government’s decision to focus on the structural surplus and to delay reaching nominal balance may not be justified, given that there is some mismatch between assessments of the economic cycle. Although the economy as a whole is below its potential output, rapid growth in employment, wages and private consumption have increased the tax take and so the negative impact of the economic cycle on the fiscal position is smaller. If the target of nominal balance is repeatedly pushed back, this will pose a threat to strict fiscal discipline and will not allow the state to increase the reserves it would use to balance the economy if the downside risks should be realised.