Bank of Estonia: Drawn out economic recession underway

According to the latest economic forecast of the Bank of Estonia, Estonia's economic recession will be longer than previously thought. Photo: Sander Ilvest

According to the latest economic forecast of the Bank of Estonia, Estonia's economic recession will be longer than previously thought, the main reasons for which are the poor condition of Estonia's export markets and reduced competitiveness.

According to the forecast, the Estonian economy will fall by 3.5 percent this year and by 0.4 percent in 2024. Faster economic growth is expected from 2025 onwards. The shrinking economy will lead to a slight increase in unemployment next year, but people's purchasing power is forecast to continue to improve as price increases have been subdued, the central bank said. Opportunities for faster economic growth at close to 3 percent are expected in 2025 and 2026.

This year has turned out to be more difficult for the Estonian economy than expected and the recession will last longer than previously expected. The sales possibilities of companies in the domestic market have been limited by people's uncertainty about the future and the increased saving resulting from this. However, sales to foreign markets have been hindered by the poorer performance of the main export markets compared to the European economy as a whole and the appreciation of the exchange rate with the Nordic countries.

An important role has also been played by the rise in production costs and the disruption of several existing supply chains and the demise of business models due to the war. Uncertain circumstances and higher interest rates have not favored the addition of new investments either.

All in all, the Estonian economy will be shrinking this year for the second year in a row, and the expected decline will reach 3.5 percent. Estonia's economy is expected to experience a small 0.4 percent decline in 2024 as well, because the demand for goods and services on the domestic and foreign markets will only gradually recover.

The impact of the economic recession is reaching the labor market more and more strongly. So far, companies have tried to avoid job cuts, which is why total employment has remained at an all-time high despite the nearly two-year recession. Retaining employees has become possible thanks to the expectation of an imminent recovery of the economy and a decrease in real wages, which has made labor cheaper for employers. However, a large drop in productivity signals the underutilization of employees and the more pessimistic near-term forecast will lead to an increase in unemployment, which will peak at 9 percent in 2024.

The cooling of the labor market will reduce wage growth. Decreased labor demand and the slowdown in price growth are also reflected in the subsiding of wage growth. In 2024, the already concluded collective wage agreements in the public sector and the increase of the national minimum wage to 820 euros will prevent wages from fully adapting to the more meager economic conditions. The average salary will increase by 6.6 percent in 2024 and will decrease to around 5 percent in the following years.

However, according to the central bank, the minimum wage increase of more than 13 percent that will take effect next year will likely be too much for several companies with lower productivity and lower wage levels and part of the increase in unemployment will be due to the increase in the minimum wage.

People's purchasing power is continuing to improve. In a little more than a year, the purchasing power of the average salary has recovered by half. However, the remaining half of the recovery will take longer because, although inflation is slowing, future wage growth is also more subdued. The purchasing power that preceded the rapid rise in the cost of living will probably be restored in 2025, the central bank estimates.

The slowdown in price growth is continuing. The cost of the consumer basket has remained relatively unchanged for more than half a year and the current inflation reading of 4-5 percent is caused by a lower reference base from a year ago. Next year, the price level will be raised by VAT and excise hikes and the consumer basket will become more expensive by 3.4 percent. In 2025-2026, the expected price increase will remain slightly above 2 percent. The price increase is slowed down by weak economic activity and some sectors have buffers for price revisions at the expense of the profit margin.

Drafting the state budget will become even more difficult. As the economic cycle will be weaker than usual in the coming years, fiscal policy support would be appropriate to boost the economy. At the same time, the budget is already in a permanent deficit as a result of previous decisions, on the surface of which additional stimulation would mean an even bigger deficit, increasing the state's debt and interest burden in an accelerating manner. The possibilities for this are also limited by the possible conflict with the rules valid at the national and European Union level. Since tax revenue growth will most likely remain below what has been forecast so far, there is increasing pressure to limit the growth of expenses or to find new sources of revenue to prevent the debt spiral from deepening.