The size of the economy exceeded its potential

  • Growth accelerated in the first quarter in many countries
  • GDP growth was boosted by a recovery in output in the oil shale sector
  • Investments increased substantially

The Estonian economy grew by 4.4% over the year in the first quarter, and by 0.8% over the quarter. The size of the economy exceeded its potential output volume rather than remaining below it. This indicates that companies are using their production capacity more than usually, and it is hard to find the new employees needed for activities to expand. Further growth in the economy requires increased investment and productivity growth. The danger has increased though that the balance of the economy may worsen.

Growth accelerated in the first quarter of the year in many countries, including Estonia’s neighbours. The economies in Latvia, Lithuania and Finland grew by some 1.5% in the quarter. Quarterly growth in Estonia was a little lower, as it had accelerated in the fourth quarter of last year because of the stocking up of goods subject to excise. This meant that the contribution of net product taxes to GDP growth was smaller in the first quarter. Without the negative effect of net product taxes, the Estonian economy would have grown by 4.8%.

One reason for the faster growth in the economy was that oil-producing states have exited their recession, meaning that demand stopped falling in those countries. One country this applies to is Russia. The higher oil price is reflected in the Estonian economy primarily by the oil shale sector, and mining and energy made a large contribution to economic growth in the first quarter. More detailed data show that the financial results for oil shale oil producers were notably better than a year earlier. Equally though, the rise in the oil price has given a lift to inflation, restraining growth in private consumption. Private consumption at adjusted prices was only 0.6% more in the first quarter than a year previously.

The demand component of GDP that saw the biggest growth in the first quarter was investment, which was up 16.5%. This was also reflected by indicators for the construction sector, which have strengthened steadily since the start of the year. A recovery in investment is needed to shore up the supply side of the economy. Private sector investment has declined in recent years as corporate profits have shrunk, and this has reduced the potential for growth in the economy. This means it is now not possible for the Estonian economy to attain the levels of growth seen before the crisis, and the problem of imbalance in the economy may already arise at lower GDP growth rates.

The danger of increased imbalance is indicated by estimates that companies give of labour shortages, and also by the rapid increase in the use of production capacity. In recent years, some of those indicators have been above the average of the business cycle, and some have been below, but in the past few months these statistics have pointed to the economy outstripping its potential.

In such circumstances the government needs to be careful about stimulating the economy. As there are few available resources in the economy, an additional stimulation could lead to higher prices, which would make it harder for companies to invest. Widening a positive output gap through the budget would increase imbalance and so amplify the economic cycle, possibly ending in the economy crashing. Furthermore, it is wise to build up buffers in good times against possible rainy times in the future.

Survey data from companies looking to the months ahead indicate somewhat slower growth in the industrial sector, though expectations for output are still strong and show no sign of falling. Estimates of orders for the construction sector, which is focused on the domestic market, were above the average of the first quarter in April and May.

Source: Bank of Estonia

Author: Kaspar Oja, Economist at Eesti Pank

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