Despite the gradual drop since 2014, investments’ share in Estonian GDP still the largest in euro area
More investments needed in manufacturing sector
Wood sector makes the largest positive contribution to manufacturing sector investment growth.
Investment share in GDP highest in euro area
Although the volume of total investments has been decreasing since 2014, investments’ share in GDP is still the largest in the euro area. Roughly 65% of
investments in Estonia come from the business sector, whereas in the EU the average is 60%.
Investment structure needs improvement
Comparing the long-term investment structure of Estonia to the EU average, there are some large differences. In Estonia, considerably more investments have been
made in the fields of electricity generation and transportation, whereas manufacturing sector investments are lagging. In Estonia, manufacturing sector investments make up roughly 12% of total investments, much lower than the EU average of16%, even though the manufacturing sector is relatively more important in Estonia.
Manufacturing sector hampered by rapid wage growth and lower
The decrease in manufacturing sector investments is influenced by falling profitability, which, in turn, is a result of multiple factors: demand is weak and prices are falling, while labour costs are biting profitability. The situation is different among the subsectors of manufacturing. The wood industry has increased its share in investments, whereas the food industry has had a long period of decreasing investment volumes (although the situation has shown improvement in recent quarters). The manufacture of electronics and electrical equipment, on the other hand, has witnessed a serious decrease in profitability, and investments’ share of turnover has fallen very low.
In the latest April 2016 edition of the Swedbank Economic Outlook, the bank noted that Estonia is in need of more investments. Although the decline in total investment volumes slowed towards the end of last year, business sector investments have not yet shown a clear-cut improvement. This overview tries to shed some light on the Estonian investment structure in general and, in particular, on the situation of manufacturing sector investments.
Investments’ share of GDP highest in the euro area
Although the share of investments in GDP has been in a decline since the second half of 2014, the situation is not that bad in comparison with the rest of the euro area. Of the 19 euro area countries, Estonia has had the biggest investment share of GDP since 2011. In fact, it has had one of the largest for the past 20 years. Part of this can be written to the account of reinvested earnings not taxed in Estonia, a unique system of taxation put in force in 2000. According to the 2015 international tax competitivness index, Estonia has the most competitive tax system of OECD countries. The World Bank has ranked Estonia 6th globally in terms of ease of doing business. Investments’ share in GDP skyrocketed to 37% in 2007. The financial crisis of 2008 naturally took a toll on the share of investments, which showed a healthy recovery in 2010-2014. The recovery was supported by a cycle of increased demand in the world economy and larger investments in the renovation of dwellings, supported by funds from the trading of carbon dioxide quotas. However, the share of investments in GDP has been in decline since 2014.
In the euro area, on average, investments make up nearly 20% of GDP, whereas in the Baltics this share tends to be larger. The share of investments in GDP is relatively similar in Latvia and Estonia. In Lithuania, the share is somewhat smaller and the recovery of this indicator, after the financial crisis, has been slower but shows a steady pace. Roughly 65% of total investments in Estonia are business sector investments, while in the EU this number is 60%. Government sector investments account for more and households less than in the EU on average.
Even though Estonia has a large volume of investments in the euro area, a decline in this
volume of investments, together with a shrinking labour force, will not contribute positively to the future growth of the economy. The share of investments in GDP has fallen to the lowest level in 20 years, except in 2009-2010. In recent years, differences between euro area and Estonian GDP growth have shrunk. Without further investment growth, especially in R&D, machinery, and equipment, it will be hard to raise productivity or production volumes and catch up with average living standards in the euro area.
Investment structure needs improvment
The long-term investment structure of the total economy in Estonia is somewhat different from that of the European Union (EU), based on 2004-2014 average figures. Out of total investments in the economy, considerably more has been invested in the fields of electricity generation, transportation/storage activities, and agriculture. Investments related to electricity generation accounted for 4.4 percentage points (pp) more than the EU average in 2004-2014 and 7 pp more in 2010-2014. On the other hand, investments in manufacturing accounted for 4% less than the average in those EU countries for which Eurostat has data.
Therefore, the structure of investments, in recent years, has been tilted towards electricity generation, leaving other sectors in the shade. Investments in electricity generation have been necessary in the context of the opened electricity market. The EUR 638 million invested in the Auvere power plant makes up the majority of these investments, which have been focused on increasing the productivity of electricity generation and staying competitive in the international market. Although these investments have been necessary, the strategy for generating sustainable GDP growth probably doesn’t lie merely in electricity exports.
Investments in the manufacturing sector are important in order to increase productivity or production volume and start making higher-value-added products.
Investment growth contributions in the business sector show different causes for the negative growth in recent years. In 2014, investment growth was negative, mainly due to reduced investments in the electricity sector after the Auvere power plant had been constructed. In 2015, though, the decline in investments was more broad-based, with the transportation/storage and agricultural sectors making the largest negative contribution.
Russian sanctions, the reduced purchasing power of its citizens, and political decisions, as well as reduced export volumes, played a role in the decrease of transportation and storage activity investments in 2015. Investments in the agricultural sector were influenced by low market prices and a break in the agricultural subsidies programme. Rising real net wages and strong private consumption encouraged trade-related enterprises to increase their investments, thereby making a positive contribution to total investment growth. The contribution of manufacturing sector investments has, in recent years, vacillated between positive and negative territory without showing any clear-cut improvement.
Manufacturing sector hampered by multiple factors: weak demand, strong wage growth, and lower output prices
The Estonian economy is small and open, relying heavily on exports. Approximately 60% of total export volume come from the manufacturing sector, which, in turn, exports 70% of its turnover. In 2015, there was practically no change in the investment volumes of
manufacturing enterprises. In fact, investments in the manufacturing sector have not picked up since the 2008-2009 crisis. Before the crisis, the share of investments in manufacturing sector enterprises was close to 8% of their turnover, whereas, for the past five years, it has been close to 4%. The situation varies in different manufacturing sub-sectors. For example, the wood sector has shown significant growth in its share of investments, while the shale-oil products sector has seen a massive cut due to low oil prices.
In Estonia, roughly 12% of total investments in the economy are made by the manufacturing sector. In the EU28, this number is close to 16%, even though the manufacturing sector is relatively more important in Estonia than in the EU on average.
One way of measuring the importance of the manufacturing sector is to look at how much value added is being produced, and how many people are employed in the sector. In the EU28, employment, as well as the share of value added in the manufacturing sector,
accounts for 15% of the total. In Estonia, the value-added share of the manufacturing ector
is similar (16%), but the share of people employed is larger. Comparing these two figures also gives an idea of the efficiency of the sector. For example, in Germany, only 19% of people are employed in the manufacturing sector, but the sector produces 23% of the total value added in the country.
In Estonia, the gap between the share of value added and the share of employment in the manufacturing sector had, until 2012, been closing quite quickly, indicating an overall increased productivity. Productivity growth has been lagging since, and it is hard to increase it without further investments in technology.
There are several factors influencing investments in the manufacturing sector. One key factor, profitability, is of the utmost importance to entrepreneurs. Looking at the long-term average, we see that profitability has been around 8-9%. After recovery from the financial downturn, the share of profits in the turnover of manufacturing enterprises has been constantly falling, thus explaining the weak confidence about increasing investments.
The reasons for the fall in profitability are wide-ranging. The share of labour costs has been constantly rising and will soon reach the pre-crisis level. This could be kept under control with investments in efficiency, so that fewer people would produce the same amount of output. At the same time, export and import prices have been falling for the past five years, with export prices falling more heavily than import prices. These two factors are both having a negative impact on profitability, which, in turn, hampers investments growth.
Manufacture of food products and beverages, on the other hand, has shown a decrease in investments’ share, whereas labour costs have been on the rise. Production volumes declined 2% last year, mainly due to decreased exports to Russia. Last year, the export volume of milk products to Russia declined by 4.5 times and exports of beverages by 2 times. Long-term average profitability of the food and beverages sector is roughly 4%, but this figure has currently fallen below 2%. The future seems optimistic, nevertheless, as investments have started to increase and the labour cost rise has smoothed out. According to the survey by Swedbank, mentioned above, 37% of enterprises in that sector plan to increase investments this year.
The situation in the electronics and electrical equipment manufacturing industry, which has the biggest share in manufacturing industry turnover, is somewhat different. The profitability of the sector has decreased the most, and the share of investments has fallen below 2% of turnover, with labour costs rising. The sector has been extensively using a rental labour force since 2010, which means that the actual effect of a labour cost increase on the sector is even bigger. Although orders in the electronics sector increased since November last year, March data shows a 19% drop, year on year. Therefore the future of electronics sector is still unconfident.
All in all, there is a need for investments, as well as the hope that the investment climate will improve during this and the next year. This is also our main scenario in the Swedbank Economic Outlook. Growth of investments is also bolstered by an environment of low interest rates, expected to last at least a couple of years and supports investments financed by loans.
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