Bank of Estonia sets 2018 economic growth forecast at 3.5%

The Estonian economy is moving from very good times into just good times, the Bank of Estonia said on Tuesday, announcing its latest economic growth forecast, which is set at 3.5% for this year, 3.6% next year, and 2.5% in 2020.

The Estonian economy has shown signs of weakness at the start of this year, according to a Bank of Estonia press release. Is quite natural for growth to be slower as there have been fewer unused production resources available with which to grow, and investment statistics indicate that new production capacity is only slowly being added. Higher employment has thus far helped to offset the lack of investment, and has been made possible by net immigration in recent years, a temporary increase in the working age population, and more active participation in the labour force, though these beneficial influences are fading.

A consequence of the low level of investment by the business sector is that long-term growth in the economy will be slower. Corporate spending on investment as a ratio to value added has for the past three years held at its crisis-period level, which is below the average for EU member states. Estonia has also been somewhat less attractive for foreign investments. Assuming that funding conditions remain favourable and given that successful business models require investment in new technology, especially when there are labour shortages, capital needs to be built up over the next two years, though the outlook for this is uncertain.

According to the Bank of Estonia, the state should support investment by businesses by keeping economic policy stable.A survey by the European Investment Bank (EIB) finds that companies see the political and regulatory environment as a larger source of short-term uncertainty than the general economic climate or the outlook for their area of business and financing conditions, and the state needs to take account of this alongside its direct measures to develop enterprise when setting its economic policy.

Bank of Estonia: Competitiveness concerns looming for Estonian economy

Although growth is slowing in the economy, the economy will still be running at above its potential level for the next two years.As part of the growth in the economy has been driven by increased demand, not by the addition of production capacity, the economy is temporarily above its level. Businesses are not able to increase their production volumes consistently at the same rate as demand, and growth is expected to slow by the end of the forecast horizon.

Government must be prepared to make spending cuts if necessary

The budget surplus planned in the state budget strategy is appropriate for the economic conditions of the years ahead.A nominal surplus and structural balance in the state budget will help to balance the economy at a time when it is running above its sustainable level.

According to Bank of Estonia assessments, however, the forecast for revenues may prove too optimistic and targets in the state budget strategy may not be met if the government is not prepared to make spending cuts should tax revenues grow by less than expected. Tax revenues may be lower than expected if changes in tax policy have less impact than calculated or if there is a sharp slowdown in growth in the economy. As both spending cuts and the need to find new sources of revenues will rapidly reduce confidence in the economic environment, it would be sensible to plan the budget with a margin for flexibility.

IMF: Wage pressure biggest threat to Estonia's economic outlook

Outlook in foreign markets less certain

The danger has increased that growth will slow more steeply than forecast due to unexpected events.This could be caused by deterioration in terms of trade and setbacks in foreign markets, where the outlook has become less certain. The threats of barriers to international trade have started to become real, which has increased the probability of battle lines continuing to be drawn and having a major impact on the global economy.

Companies and households are better protected against a deterioration in the economy than they were earlier.Even if the economy should be hit by some unexpected shocks, both companies and households are better prepared as they have built up savings in recent years and their debt burdens are lower.

Inflation to continue falling, wage growth to continue to grow

Inflation is falling.The rise in consumer prices peaked at the end of 2017 at close to 4%. Inflation started to fall in early 2018 and will be down to around 2% by 2020, which, while still somewhat higher, is close to the rate for the rest of the euro area. The main cause of rapid inflation is fast growth in costs in Estonia, particularly the growth in labour costs.

The rapid growth in labour costs shows no signs of fading.The very strong upwards pressure on wages shows that the reduction in the effective income tax rate that came in at the start of 2018 did not halt the growth in gross wages, meaning that employers had to increase their wage costs almost as fast as earlier, so that net wages increased for a large share of employees even more because the tax changes. Wage growth is expected to remain close to 6% in the years ahead, meaning that employers will have to continue to cope with rapidly rising wage demands.

Participation in the labour market will be increased by a rise in the retirement age and in life expectancy, and an improvement in health indicators.Labour force participation will be encouraged by the work ability reform, which has been successful in part due to the favourable economic climate. When the economy is doing well, it is easier for those with less professional training to find work. Unemployment could increase sharply, however, if the economy were to cool unexpectedly, as an end to the trend of growth in the economy would make conditions difficult especially for companies providing low productivity jobs.

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