The rapid rise in labour costs may restrict investment opportunities

The long-awaited acceleration in economic growth materialised in the second half of 2014, but unfortunately labour productivity grew more slowly than in the first half of the year. Growth accelerated mainly as additional labour was employed, while the contribution of capital to growth declined.

After a long period of sluggish economic growth the growth in labour costs started to slow down in the first half of the year, but accelerated again in the second half. Employment growth picked up in the second half of the year. Although the average wage grew notably more slowly in 2014 than in 2013, companies were able to recruit additional labour in the second half of the year at the cost of faster wage growth.

The shortage of labour due to long-term factors is preventing any reduction in wage pressure. Demographic processes mean that the number of working age people is falling by around 0.8% a year and in the coming years the smaller birth cohorts will be leaving higher education facilities. Although the net migration balance improved for the second consecutive year, Estonian employers are still having to compete in the labour market with foreign employers. The workers going abroad who get a relatively bigger wage boost by doing so are those who would be earning a relatively low wage in Estonia. Not only is the flow of new entrants to the labour market shrinking, but the utilisation of labour is already high: the share of the working age population that was employed climbed higher in the second half of 2014 than it was at the peak of the economic boom.

The faster rise in labour costs than in productivity raised the labour share in GDP, while profits decreased. This may threaten the competitiveness of exporting companies as it will put them under pressure to raise prices. If competition makes it impossible to raise prices, then their lower profitability may push companies to reduce employment in Estonia. Nominal unit labour costs have risen by 17.5% in the last three years, which is more than twice the 9% level where the alert mechanism of the European Commission’s assessment is triggered.

There was no increase in corporate financial difficulties in the second half of 2014 and early 2015. Redundancy payments remained at about the same level as in the previous years, as did the number receiving compensation because their employer had gone bankrupt, and the number of unemployed who had lost their job through redundancy or through their employer closing down. Companies are able for now to cover the rapid rise in labour costs from their own profit buffers, and this will probably be aided by expectations of a recovery in foreign demand and favourable financing conditions. The ability to increase labour costs at the expense of profits will inevitably be reduced in the longer term. Reduced profits also threaten the ability of companies to invest in higher productivity and in the human capital needed for more complex and higher-value work. The key question in the development of the Estonian economy is whether value added can be created with a smaller labour force than before but through increased human capital.

Source: Bank of Estonia

Authors: Orsolya Soosaar and Natalja Viilmann; Economists at Eesti Pank

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