According to the latest economic forecast by the Bank of Estonia, the recession in the Estonian economy will last longer than previously expected, mainly due to the poor position of Estonia’s export markets and the loss of competitiveness; the forecast expects the Estonian economy to contract by 3.5% in 2023 and by 0.4% in 2024, while faster growth is expected from 2025 onwards.
The shrinking economy will cause unemployment to rise slightly in 2024, although people’s purchasing power will improve as inflation has fallen.
The year 2023 has proved harder than expected for the Estonian economy and the recession will last longer than previously predicted, according to the central bank.
“Sales opportunities for companies in the domestic market have been limited by people’s uncertainty about the future, which has led them to spend less and save more. Meanwhile, sales in foreign markets have been constrained by the fact that the main markets for Estonian exports have performed worse than the European economy as a whole and by the appreciation of the exchange rate against the Nordic countries,” the Bank of Estonia said.
Rising production costs have played a major role, while the war in Ukraine has disrupted some previous supply chains and made business models obsolete. Uncertain times and high interest rates have not encouraged new investment, the central bank said.
Unemployment to rise in 2024
“Overall, the Estonian economy will have shrunk for the second year in a row [in 2023], and the decline is expected to be of 3.5%. The economy is expected to shrink a little further in 2024 as well, by 0.4%, as demand for goods and services will start to pick up only slowly in both the domestic and foreign markets. Faster growth of close to 3% may be expected in 2025 and 2026.”
The impact of the recession will be increasingly felt in the labour market. Companies have so far tried to avoid cutting jobs, and so total employment has remained at its highest ever level for two years despite the downturn in the economy.
“They have been able to hold onto employees because of the expectation of an imminent revival in the economy and because real wages have fallen, making labour cheaper for employers. The large fall in productivity indicates though that staff are underemployed, and increasing pessimism about the near-term outlook is causing unemployment to rise, and it will peak at 9% in 2024,” the Bank of Estonia noted.
“The labour market cooling will restrain the growth in wages. Reduced demand for labour and lower inflation will help apply the brakes. The collective wage agreements that have already been signed in the public sector together with the rise in the national minimum wage to €820 will make it harder for wages to adapt in full to the weaker economic climate in 2024.”
Inflation to continue to slow
According to the forecast, people’s purchasing power will continue to improve. The purchasing power of the average wage has recovered half of what it lost in just over a year, but it will take longer to recover the other half as wages will rise more slowly in the future, even if inflation is lower. By 2025, purchasing power is likely to be back to where it was before the sharp rise in the cost of living.
“Inflation will continue to fall. The cost of the consumer basket has not changed much for more than half a year, and the current inflation rate of 4-5% is a consequence of the low reference base from a year ago. The price level will be raised next year by the increase in VAT and excise duties, and the consumer basket will become 3.4% more expensive. Inflation will remain slightly above 2% in 2025-2026. Inflation will be dampened by the weakness of economic activity, and buffers in some sectors are such that cheaper energy and raw materials and narrower profit margins will allow prices to be lowered”.
According to the Bank of Estonia, the state budget will become increasingly difficult to balance. It would be appropriate to use fiscal policy to support the economy in the coming years, when the economic cycle is weaker than usual. However, the budget is already in a persistent deficit due to decisions taken in the past, and adding additional stimulus will deepen the deficit and increase the government debt and interest burden even faster, the forecast says.
“A possible conflict between domestic and European Union fiscal rules may also complicate matters. Tax revenue growth will most likely be lower than previously forecast, increasing the pressure to restrain expenditure growth or find new sources of revenue to prevent the debt spiral from worsening.”
The Bank of Estonia is the country’s central bank. Since Estonia adopted the euro on 1 January 2011, the Bank of Estonia’s main task has been to contribute to price stability in the euro area.