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.

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

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