Estonian wage pressures have not eased

  • An improved external environment and higher productivity are boosting economic growth
  • Rising food and energy prices will put an end in the second half of the year to the deflation that has been present for two years
  • Wage pressures have not eased, and growth in the average wage remaining close to 5% will force companies to make their production more efficient or exit the market

The Estonian economy will grow faster this year and in the next two as the external environment improves and productivity increases. Demand from trading partners has grown in the past six months at the rate that was forecast, and the data indicate that growth momentum will be maintained. In the short term growth will be boosted by increased productivity per employee, as the number of hours actually worked by the full-time employed has been temporarily reduced in expectation of improved demand to come. In the longer term it is only investment and employee development that can ensure higher productivity, and these should be supported by economic policies that favour growth and by increased competitiveness at both the state and company levels.

Increased investment alone is not enough to improve the growth capacity of the economy. The ratio of investment to GDP in Estonia is one of the highest in Europe, but the structure of investment should also be considered, and how efficiently the fixed assets acquired are used. The share of investment going into research and development in Estonia is one of the smallest in the European Union and so support for innovation is not strong. At the same time, the utilisation rate of production resources has been below the European Union average, which means that a relatively large part of the fixed assets acquired and the spending on them has been ineffective and has not supported growth.

The Estonian economy will become larger in the middle of this year than at its pre-crisis peak. The state of the economy is quite different from what it was during the boom some ten years ago, as corporate production capacity which is sustainable in the long-term is around 10% larger than the level of that time, and the economy is close to balance. Growth may still be forced slower by risks stemming from the external environment, the most important of which are the unsustainability of the growth in neighbouring countries that is founded on consumption; the migrant crisis, which is yet to be resolved; Brexit; volatility in commodities prices; complex geopolitical circumstances; and the bursting of a bubble in Swedish asset prices.

An accommodative monetary policy and access to funding aid growth in the economy, though the limited amount of labour available poses a problem. The central question for economic development is not how the supply of labour can be increased but how the actual available labour can be better used than before now. Sectors with low value added are particularly feeling the labour shortages, as their low average wages are hurting their competitiveness in the labour market.

Companies with low productivity and low wages exiting the market is a part of economic development. The movement of workers to jobs with higher productivity and higher wages will leave the structure of the economy more based on value added and will increase the incomes of residents. At the same time the changes in the structure of the economy should be in line with the redeployment of workers. Excessive pressure on companies with low productivity, one source of which could be steep rises in the minimum wage, could raise unemployment and harm the long-term outlook for growth.

Wage pressure has not eased and labour costs increased further at the start of this year at the expense of profits. Profits will stop declining when labour productivity increases. This will be aided by the flexible labour market, which has an institutional architecture that lets it adapt relatively easily compared to those in other countries. Collective agreements play only a small role beyond setting minimum wages and employers can decide directly about their wage costs. Even so it is possible that companies have been holding on to employees and raising wages because of overly optimistic expectations of growth in demand, and so wage growth could slow sharply.

Rising food and energy prices will put an end in the second half of the year to the deflation that has been present for two years, but for the year as a whole consumer prices will be at the same level as they were last year. Inflation will remain between 2% and 3% in the next two years and a large part of the rise in prices will come from tax rises, as excise increases on fuel, alcohol and tobacco. Higher inflation will restrain the rise in real household incomes, and that will then hold back growth in consumption over the next two years.

The financial situation of the Estonian general government is good and the budget has remained in surplus in recent years. However, the surplus has not been planned but has resulted from tax revenues being larger than expected or planned investment being postponed. Eesti Pank forecasts the budget position will be close to balance in the years ahead too, but there are major upside and downside risks. The structural balance rule in the State Budget Act ensures the long-term stability of state financing, but in order that companies and households not be faced with uncertainty about the future due to the government needing an unplanned additional source of funds, the government should set the target of keeping the budget in structural surplus or should allow more flexibility in its spending.

In the new budget strategy the government has put smoothing the economic cycle to the forefront and achieving nominal balance has been postponed. However, it will be harder in future to achieve balance. The budget was in surplus in recent years even though government wage costs increased rapidly and social benefit payouts increased strongly. This was possible because of a fall in capital expenditure and a tax-rich economic environment. Wage growth will slow in Estonia in the years to come and therefore the tax burden will decline, while the government is planning to increase investment, meaning pressure will increase to limit costs so the budget can stay in balance.

Source: Bank of Estonia
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