Prices temporarily declined compared to last year

Data from Statistics Estonia show that prices did not change for consumers during June but they were 0.4% lower than a year earlier. The main reason for the fall in prices was that electricity was 13% cheaper than a year earlier. The price of electricity hit a record peak last June as generation capacity in the Baltic states was restricted by interruptions to supply, but in June this year the electricity price on the power exchange was one of the lowest ever recorded. Prices also fell for fruit and vegetables and for communications services.

Preliminary assessments show that inflation in the euro area stood at 0.5% in June, which was the lowest for several years. Although inflation is picking up in the euro area, it will remain modest as economic activity there is only growing slowly. Low price pressures in the external environment and lower prices for imported goods contributed a significant amount to the fall in Estonian prices, with durables that mostly include imports falling in price by 3.6% in June. An exception was motor fuels, which rose in price by 0.8% as global oil prices started to rise in response to geopolitical tensions. The oil price in euros has been stable since 2011, fluctuating within a narrow range of 80-90 euros a barrel.

Although falling prices generally hinder economic growth, the effect this time is rather the opposite, as falling prices driven mainly by energy prices favour both households and companies. Falling prices reduce economic activity if the fall continues for a long time as they can cause consumption decisions to be postponed. The current fall in prices will prove only temporary because inflation will pick up in the second half of the year as energy prices stop falling and food prices rise more quickly. Eesti Pank’s forecast expects that prices will rise by 0.8% in 2014.

Source: Bank of Estonia

Author: Rasmus Kattai, Head of the Economic Policy and Forecasting Division, Eesti Pank

Recession in the distorting mirror of the state budget

The sustainability of state financing is measured in Europe by the structural fiscal balance, which indicates what the budget balance would be if it were not affected by the cyclical position of the economy or one-off factors. When the economy is growing fast, a nominal surplus is needed for the budget to be at least in balance structurally, and the opposite also applies, so when the economy is temporarily operating below its long-term growth potential, the nominal fiscal position is worse than the structural position. Structural budget balance or a small surplus is necessary so that the public finances would remain good over the longer term and the general government debt would not grow. The Estonian government debt is the smallest in Europe and the surplus targeted in the budget strategy is more than the minimum required by the European Union. However, both the previous and the current governments have relaxed the fiscal targets. In the latest budget strategy for 2015-2018 set by the new government, the government target is a structural budget surplus of 0.2% of gross domestic product (GDP). A year ago the previous strategy aimed for a surplus of 1.0%.

The structural position planned in Estonia’s national budget strategy meets the criteria observed by the European Commission, but whether the targets that have been set are actually fulfilled is another question altogether. The main debate is around the assessment of the current and future cyclical position of the economy. Both the European Commission and the Estonian government measure the economic cycle using the GDP gap, which shows how far GDP is above or below its potential, or its long-term capacity for growth. Measuring the current GDP gap is an inexact science and estimates only prove their accuracy during the subsequent years as more statistical data become available. This means that discrepancies can ensue in estimates of the structural budget position and in opinions on government activity, and debate can arise.

Measuring the economic cycle and estimating the cyclical effects on the budget becomes even more complicated if the structure of the economy is changing at the same time, and this has been the case with the Estonian economy recently. Economic growth has slowed to close to zero and GDP actually shrank at the start of this year, but wages and household consumption increased rapidly at the same time because of the decline in the population, emigration and structural unemployment. Some three quarters of government revenues comes from taxes on labour and consumption, and the sharp drop in economic growth did not directly affect that, so revenues to the state budget have increased by substantially more than the general cyclical position of the economy would suggest.

It is also important to be quite careful in forecasting the structural budget revenues, as they largely dictate the level of expenditure that the government will be able to sustain over the longer term. The most recent forecast from Eesti Pank expects the cyclical effect on the fiscal position to turn positive next year already, though the economy as a whole will remain below its potential. This means that tax revenues are already close to balance and will pass that point next year. By this interpretation of the cycle the state should limit expenditure growth to the same degree and put some of the tax revenues into the reserves. If the estimates of the economic cycle that are based on a negative GDP gap are used as a guide now, the consequence could be that the budget later turns out to have remained in structural deficit and the fiscal targets set in law prove to be unattainable. In the long run this could create problems of fiscal sustainability as the reserves built up in the good times prove insufficient to finance the deficit through more difficult times. The government has three options in that case. The first is to increase the general government debt and leave some of the costs to future generations; the second is to cut spending; and the third is to raise income, which generally means increasing the tax burden.

Source: Bank of Estonia

Author: Ardo Hansson, Governor of Eesti Pank

Economic growth will start to pick up this year

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.

Read more from Bank of Estonia website

Growth in domestic demand increased the current account deficit

The current account deficit rose to 3.7% of GDP in the first quarter of this year. The deficit mainly worsened because the trade deficit increased. The earlier surplus on the goods and services account was replaced by a small deficit, which ran at 0.2% of GDP of the quarter. This reflects the relative strength of domestic demand compared to demand for exports. Domestic demand at current prices grew by 4.8% over the year, while GDP grew by 2.6%, and while GDP at constant prices fell by 1.4% over the year, domestic demand and its components increased.

The current account deficit as a share of GDP was the same size as at the start of 2011 and 2012. Such a deficit in one quarter in isolation does not give grounds for worry about balance in the economy, especially as the Estonian goods and services account was practically in balance and external demand was below its long-term trend. A positive point for the longer term is that the growth rate of investments in fixed capital was faster than that for private consumption and stood at 6.5% at current prices. Over a longer horizon this will improve the outlook for Estonian growth. It would be a cause for worry if the decline in the current account were to continue at the same rate in subsequent quarters, as an economy as open as the Estonian one cannot grow sustainably through domestic demand alone.

The financial account saw net inflows of capital of up to 2% of GDP, with non-debt generating cash flows dominating.

Source: Bank of Estonia

Author:  Andres Saarniit, Economist at Eesti Pank

Recovery of the economic growth will be sluggish

Statistics Estonia revised the decline of GDP to 1.4% yoy (flash estimate showed decline by 1.9%) and to 0.7% qoq (flash estimate -1.2%). GDP nominal growth decelerated steeply from 5.7% in 4Q 2013 to only 2.6% in the first quarter this year.

Decline of the value added in transport, construction, energy and primary sectors inhibited economic growth the most. Decrease in transport and storage services due to the decline in transit has been behind the weak results of the transport sector. Decline of transport sector decelerated the economic growth last year the most and we expect that it will have negative contribution to the GDP growth this year as well. Weak results in energy sector were related to both less consumption and production of energy due to unusually warm weather, as well as partial substitution of locally produced electricity with imported one. Construction depends largely on public sector orders and foreign financing and we do not expect considerable improvement of these sources this year. Therefore, we expect that contribution of the construction sector will be negative to the GDP growth this year. Weak foreign demand and decrease in exports is behind the decrease in manufacturing value added. At the same time, electronics products predominantly contribute to the decline in exports. Besides mining, several services’ sector, incl. non-market activities supported the GDP growth. Although retail trade showed strong growth (12% yoy), value added in wholesale trade decreased by tenth.

Besides the decline in value added domestic demand increased with the support of the private consumption and investments (increased respectively by 2.3% and 3.5%). Although private consumption will remain the main contributor to the economic growth, its effect will decrease next year due to the expected deceleration of real growth of wages and decrease in employment. Growth of gross fixed capital formation came mainly from the non-financial corporations’ investments in transport equipment, while government sector investments decreased strongly.

Export of goods and services increased by 1.4% in real terms. Total exports were supported by strong growth of export of services, while export of goods still decreased. As import grew faster than exports, negative foreign trade balance inhibited the GDP growth.

We expect to face relatively weak and unstable foreign demand which will not enable robust export growth shortly. Besides that expected decrease in transport and construction sector value added will inhibit recovery of our economic growth. We shall revise downwards our GDP growth forecast for this year in the coming months.

Source: Swedbank

Inflation fell close to zero in May

Data from Statistics Estonia show that inflation in Estonia slowed in May to 0.1% over the year, and prices were also up 0.1% on April. The low rate of inflation was caused by both domestic and external factors, though the main driver was a fall in import prices. The harmonised index of consumer prices for the euro area showed inflation slowing to 0.5% in May, which is about the same as in Estonia. Estonian consumer price inflation differs from the harmonised index of consumer prices mainly as a consequence of purchases by tourists, which have a higher share of food products and smaller share of energy.

Energy prices in May were lower than a year earlier, but the fall was smaller than that in April because the fall in motor fuels prices stopped after more than a year and the fall in electricity prices was also smaller than that in April. Although energy prices did not fall by as much as they did before, this did not push inflation up as the price of the food basket grew more slowly at the same time. Food price inflation mainly slowed for unprocessed food, particularly fruit and vegetables, which fell in price.

The slowdown in inflation meant that growth in real wages accelerated in the first quarter to 6.6%, which indicates that consumer purchasing power improved significantly. Manufactured goods have become cheaper for consumers, particularly through a slowing of inflation in prices for clothes and footwear, and retail sales volumes grew by 8% in April. However, slower inflation is not clearly evident yet for consumers. Data from the Estonian Institute of Economic Research show that 33% of people felt that prices were rising fast and only 9% perceived prices as stable or falling. In the euro area 17% noticed prices rising in May and 27% saw them as stable or falling.

The unusually low inflation in Estonia right now is a temporary phenomenon, and prices will rise faster in the second half of the year. Inflation will be raised as the effect of free higher education passes out and energy prices continue to fall more slowly. The acceleration in inflation will remain subdued because the ability of businesses to raise prices is limited as demand in foreign markets will recover only gradually and price growth abroad will be slow.

Source: Bank of Estonia

Author: Rasmus Kattai,  Head of the Economic Policy and Forecasting Division, Eesti Pank

Estonian inflation stays low

In May, consumer prices in Estonia increased by 0.1% compared with last year and also last month. Regulated prices rose by 0.3% within a year. Non-regulated prices did not change.

Biggest push came from an increase in the prices of alcohol and tobacco that were lifted by higher excise taxes. The government plans to increase alcohol excise tax also next year. The planned 15% increase in the tax rate next year would raise inflation by half a percentage point.

Consumer prices were pushed lower by cheaper mobile communication services and food. The prices of food also decreased globally. Favourable weather and improved connections lowered heating and electricity prices. The prices of motor fuels increased a bit in May as global oil price climbed because of lower stocks in the US and increased tensions in Libya.

Inflation is also modest in other countries. Euro zone inflation amounted to 0.5% in May. Low inflation was one of the reasons why the ECB decided to lower interest rates. ECB measures should lower the euro exchange rate and therefore increase the prices of imported goods and services paid in US dollars. Inflation should accelerate towards the end of the year, when macroeconomic situation is expected to improve.

Source: Swedbank

Economic growth slips – what next?

As the economy saw negative growth in the first quarter, it becomes important to ask what the consequences may be and what we should consider for the future. How much of the fall is temporary or cyclical, and how much of it is long-term or structural?

The disappearance of the impact from temporary factors might make growth in the second quarter seem quite fast in quarterly terms but there is no sense in hoping that structural factors like slow growth in trading partners, problems with competitiveness or a decline in the transport sector will vanish quickly. For this reason year-on-year growth will remain quite modest in the short term. There may be an effect from the conflict in Ukraine in the second quarter, though the data do not yet indicate that this is the case. The expectations of companies were lower in March, but there was no decline in orders.

Growth in exports will not catch fire for some time

The slow growth rate was partly due to expectations of weakening demand in foreign markets. Although the situation has generally improved in Europe and the United States, economic growth in Estonia’s trading partners remains lower than had been estimated. The updated IMF forecasts for Estonia’s trading partners suggest that growth in external demand will be almost two percentage points less than was predicted in the autumn. This is mainly because of worse forecasts for Finland and Russia. A majority of Estonian manufacturing companies also consider weak demand to be the biggest obstacle to growth.

Not only is demand weak in foreign markets, but competition there has tightened, and although Estonia still has relatively cheap labour, productivity is increasing abroad. The recent rapid growth in wages has not made life easier for Estonian exporters. A survey of competitiveness in manufacturing companies carried out by the European Commission shows that there was a fall in the first and second quarters in the proportion of companies who believed their competitiveness in foreign markets had increased. It is difficult to reverse rises in payroll costs and so it may be assumed that higher production costs may affect export growth for some time to come.

Estonian exporters may also be held back by an appreciation of the euro, as the share of Estonian trade that is outside the euro area is larger than that of other euro area countries. A strengthening of the euro will restrict the competitiveness of companies exporting outside the euro area.

Domestic demand is behind the recent weakness

Export growth must have been quite strong in quarterly comparison for the fall to have been as small against the first quarter of last year as Statistics Estonia showed in their comment on GDP. Moreover, manufacturing industry, which is the main source of exports, has grown quite stably in recent quarters, even though it has declined in quarterly comparison in the neighbouring countries, even in Latvia and Lithuania. The flash estimate for the balance of payments also indicates that exports of services were strong in the first quarter despite the weakness of the transport industry. If domestic demand were to prove responsible for the whole of the quarterly economic decline, it would have to have dropped sharply.

Investments may be behind the fall in domestic demand from the fourth quarter as investments are a very volatile component of GDP that can grow by 10% in one quarter and fall by the same amount in the next. The dynamics of investment reveal a large impact from one-off transactions and the first quarter may have witnessed a temporary drop in investment, which will pass in the second quarter.

However, some of the fall in investment is certainly structural in nature. Reductions in European Union funds and money from sales of emissions allowances have led to a reduction in general government investment, and private sector orders have been unable to pick up the slack quickly.

The warm weather effect will pass in the second quarter

Warm weather and an early spring may have lowered annual GDP growth in the first quarter by as much as one percentage point due to lower energy production. The reason for this bad result was not only the warm weather this year, but also the cold temperatures last year which meant that more energy was produced than normal. On top of the fall in demand caused by the warm weather, energy production may also have been pushed down by the new undersea cable between Estonia and Finland, which has made it easier to import electricity from the Nordic countries. When prices for electricity fall in the Nordic countries it becomes more profitable to import electricity from there, meaning that Estonian electricity production is smaller. The disappearance of the weather effect could give a significant boost to growth in the second quarter.

The effect of the weather on GDP is quite large in Estonia as the power stations use locally-produced oil shale as fuel, and if electricity production falls, it is no longer reasonable to mine so much. In contrast, Latvian power stations use a lot of Russian gas, meaning that the local value added in energy is smaller.

The effect of warm spring weather in neighbouring countries can be quite different from the effect in Estonia as warm weather in early spring increases the hydro-energy production capacity in some of Estonia’s neighbours. Hydro-energy, with high local value added, replaces the output of power stations burning fuels.

Energy alone cannot explain all of the decline and the warm weather obviously had a positive impact in some industries. March last year was very cold, and this had a restrictive effect on the construction industry, but there was no such negative effect this year and construction may have grown faster, all other things being equal.

Indications of a structural economic decline

The value added of transport and warehousing has been in decline in Estonia for some time, and as this is a structural effect, it is not expected that it will return to earlier levels any time soon. There was a sharp fall in rail transport in Estonia in 2007 and it has remained low since then and even fallen slightly further. At the start of 2013 a temporary improvement was noted, but it faded away during the year. The reduction in transit has been much remarked in the transport and warehousing industries. As a large part of this industry operates the domestic transport of goods and passengers, the question inevitably arises of how long it can continue to exercise a negative influence over the economy.

Trends in the construction industry are in contradictory directions, like the trends in investment. Pushing one way, the reduction in European Union funds and income from sales of emissions allowances have led to a drop in general government investment that will not recover soon, but driving the other way is a gradual replacement of government orders by orders from the private sector. This is reflected in the results of the different branches of the construction industry. There has been a sharp drop in mining for filling materials used in road-building, like sand, gravel and crushed stone, but there has been strong growth in the production of materials for the building industry.

The real estate business also contributed to the decline in the first quarter, but as a majority of the value added in real estate comes from rent, which is largely a book value, the significant fall may only be an issue of accounting methodologies, and so the effect will probably disappear over the long term. Sizes of buildings and home ownership, or imputed rent, do not change much overnight.

It should also be remembered that the flash estimate for GDP largely backed up the weak economic figures for January and February, but several figures were looking much stronger again in March. Statistics Estonia uses a limited dataset for the flash estimate, meaning that the figures may be revised in future, and experience shows that this can happen to quite a large degree. In the first quarter of last year the flash estimate showed a quarterly decline in the economy of around 1%, but this has been revised to 0.2% by now.

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Source: Bank of Estonia
Author: Kaspar Oja, Economist at Eesti Pank and doctoral student at the University of Tartu

Weak external environment caused negative growth

Data from Statistics Estonia show that the economy shrank by 1.9% from a year earlier in the first quarter, and by 1.2% from the fourth quarter of last year.

Economic development has been weaker than was forecast by Eesti Pank in December as external markets have done less well than was expected. An important role was also played in economic growth in the first quarter by short-term and one-off factors like the unusually warm weather, which reduced energy production, and a cut in general government investment.

Prices have risen more slowly in foreign markets than was expected in the Eesti Pank forecast published in December and demand has been lower, limiting the options for exporters. The situation is further complicated by increases in unit labour costs, which have led profit margins to fall. There is still a majority of companies that believe that their competitiveness has increased, but the percentage of such companies has declined.

The economies in Europe and the USA have generally been growing, but growth in Finland and Russia, important trading partners for Estonia, has not yet started to recover. However, the impact on the economic results for the first quarter of the heightened geopolitical tensions arising from the conflict in Ukraine was probably limited. It has had a negative impact on expectations, but there has been no fall in orders.

Domestic demand growth is being restrained by the reduction in orders from the public sector for construction, which has been offset to an extent by orders from the private sector. An increase in the role of the private sector in construction is also indicated by a change in the structure of the output of manufacturing companies. It is likely that a slowing in the rise in construction prices will support growth in orders from the private sector.

Read more from Bank of Estonia website

Author: Kaspar Oja, Economist at Eesti Pank

Economy decreased in the 1st quarter

According to the flash estimates of Statistics Estonia, the gross domestic product (GDP) of Estonia decreased 1.9% in the 1st quarter of 2014 compared to the 1st quarter of 2013.

The previous time that the GDP fell was in the 1st quarter of 2010. Compared to the 4th quarter of 2013, the seasonally and working-day adjusted GDP decreased by 1.2%.

The increase in the value added of the main contributors to the Estonian economy either slowed down or their value added declined. According to preliminary calculations, in the 1st quarter of 2014, a decrease in the value added in transport, real estate activities and energy slowed the GDP growth down the most. The main reason for the deceleration in real estate is an accelerated rise in prices. The decrease in the value added in energy is mainly caused by the warm winter and by the partial replacement of own production with imported electricity.

The growth of manufacturing, which is the main contributor to economic growth in Estonia, slowed down mainly due to a decrease in the manufacture of electronic and chemical products. However, the manufacture of wood gave the largest positive contribution.  In the 1st quarter of 2014 compared to the same quarter of the previous year, due to weak external demand, there was a decrease in the exports of both manufacturing and the total economy. Real export of goods decreased for the third quarter in a row compared to the same quarter of the previous year. At the same time, after a decline in the previous two quarters, the import of goods was on the rise again.*

Real growth of GDP, export and import of goods,
1st quarter 2012 – 1st quarter 2014

Diagram: Real growth of GDP, export and import of goods

The flash estimate is calculated only by production method using the information from the Estonian Tax and Customs Board and data derived from the monthly statistical surveys.  Therefore, the estimate may differ from the revised estimates of the GDP, which are calculated by expenditure, production and income method using quarterly data. The revised estimates for the 1st quarter of 2014 will be published by Statistics Estonia on 9 June 2014.

*In National Accounts, export and import of fuels imported for processing are corrected.

Source: Statistics Estonia


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