OREANDA-NEWS. June 23, 2014. The slowdown in growth in 2013 and the decline in gross domestic product (GDP) at the start of 2014 have not so far noticeably worsened household finances or the state budget.

Wage rises have remained high in the labour market and so tax revenues have been good. The increase in the nominal size of the economy has mainly been caused by increases in production costs and product prices in recent years, but this is no longer possible to the same extent. For the Estonian economy to continue developing, state finances to remain good and household incomes to continue rising, real growth in the economy needs to accelerate.

Economic growth will start to pick up this year and will be 0.7% for the year as a whole due to weakness in the first quarter, then the economy will grow by 3.5-4% in the next two years. The decline in GDP in the first quarter was concentrated in particular sectors, most notably transportation and storage, energy, and construction. As production in the energy sector was held down by the warm winter and an increase in the share of energy imported, the negative contribution of the sector to GDP will fade out in the second quarter.

The negative contribution of transportation and storage to economic growth will also be reduced from the second quarter due to the change in comparison base, as the fall in the value added of the sector started at the same time last year. Demand in export markets, which companies say has been the biggest restriction on higher production, will start to improve gradually. As production capacity in the economy is still under-utilised, companies are able to fulfil larger orders.       

Growth has recovered at the expected rate in the euro area as a whole, but has picked up less quickly than had been hoped in the main target markets of several Estonian exports. The risk of unexpected developments in individual target markets will make it important for companies to be flexible in their range of products and target markets and in their ability to change to other markets. The deterioration in the external environment following the conflict between Ukraine and Russia at the start of this year temporarily lowered the confidence of companies and households, but the actual impact on the economy has so far been small. If tensions rise and sanctions are applied, then opportunities for exports might be more restricted than is forecast, both for direct trade with Russia and Ukraine and indirectly for trade with other partner countries. In this case the recovery in Estonian economic growth may be delayed. The ability of the Estonian economy to withstand the impact if the negative scenario is realised is better than it was in the last crisis, as the loan burden on the economy is smaller, as is indebtedness to other countries.

There will be no let up in the shortage of qualified labour in Estonia, nor in the wage pressure it causes. Wage growth will slow because the capacity for companies to increase payroll costs at the same rate as before is limited. The need for wage rises to adjust is indicated by the increase in the share of companies that are losing competitiveness, the fall in corporate profitability, and the slow growth in prices in foreign markets, which puts ever more of a limit on the ability of companies to pass wage costs into prices. In the years ahead, the public sector will need to avoid driving wage growth, as that would make adjustment of the growth in wages in the private sector harder. If wage growth slows in the private sector, the public sector needs to be ready for it to slow there too.

The forecast expects unemployment to fall slowly, as the qualifications of the unemployed often do not match the requirements of companies. To address the problem of structural unemployment, the government will need to continue with its active labour market policies, with support from regional, education and population policies. The population is shrinking and ageing, and this means that even more decisive steps need to be taken to increase the labour force participation rate. As government measures have an impact over a longer term, companies will need to help employees improve their skills in order to cope with the shortage of labour. To cope with wage pressures, companies need to invest above all in making production more efficient. The assumptions used in the forecast favour an acceleration in investment growth, as loan interest rates remain low and bank loans readily accessible.                                      
                                                                                 
The decisions of households about consumption and investment will start to be affected by a slowing of growth in incomes, and the rise in real purchasing power will be restrained by accelerating inflation in the coming years. The very low inflation in the first half of 2014 will start to pick up steadily as the economies in partner countries improve and raise the prices of goods imported into Estonia. Rises in domestic prices will also be moderate, and part of the general rise in prices will come from rising excise taxes. Inflation will rise from 0.8% in 2014 to 2.4% in 2015 and 2.7% in 2016, exceeding the euro area average. Inflation will be higher than the euro area average because the economy and incomes are growing faster.

The general government budget balance will deteriorate this year and next because the economy is weaker than was forecast earlier and because of the looser fiscal policy of the new government coalition, but the budget deficit will start to fall in 2016 under the positive influence of the economic cycle. The targets for state financing are more relaxed than before under the new budget strategy, as the goal of achieving a nominal surplus has been postponed and the goal of reaching a structural surplus stripped of cyclical effects has been adjusted downwards. Eesti Pank estimates that structural budget balance is not really achievable within the time covered by the forecast given current assumptions, as strong growth in tax revenues is inconsistent with the projected weak economic growth. Although general government finances will generally remain strong under the forecast, the budget targets should allow enough leeway that any unforeseen deterioration in circumstances should not lead to unexpected changes in tax policy. The basis for the Estonian budget strategy must be that the tax environment should be stable and reliable for both companies and households.