Factors behind the fall in exports include higher energy prices, reduced access to raw materials, and weaker demand on external markets.

Moreover, the economic contraction seen at the moment has to be offset against the fact that the economy earlier had been overheating, the Bank of Estonia reports.

Where next for the Estonian economy is likely to be increasingly a consequence of higher production costs and reduced competitiveness, Kaspar Oja, Bank of Estonia, argues.

Higher commodities prices were a major factor in prices rising steeply in Estonia last year, meaning at least that any concomitant fall on global markets likely to be followed by other prices dropping rapidly.

On the other hand, prices remaining for any length of time significantly higher than those of competitor nations will make Estonia less competitive, Oja adds.

The economy is in a weaker position than previously, but looking even further back, its position is closer to the average that the business cycle would forecast, meaning recent peaks were more indicative of overheating.

High inflation has kept up the upward pressure on wages, even as the economy has contracted, which has had the effect of labor costs rising rapidly.

As reported by ERR News, Estonian economy shrank by 1.3 percent last year, while the figure for the final quarter alone stood at 4.1 percent.

While household consumption was smaller in Q4 2022 than it had been a year earlier, the main source of this decline came from exports.

The Q4 2022 contraction was well aligned with the most recent Bank of Estonia forecast, but a larger total contraction than expected for the year resulted from state agency Statistics Estonia having revised the GDP of previous quarters downwards.

Unforeseen falls within GDP of over 40 percent for forestry in 2022, over 20 percent for the energy sector and around 10 percent for agriculture meant these branches of the economy gained competitiveness as the war in Ukraine caused prices to shift, while they might have been expected to do well out of the crisis.

Accommodation and food services made a relatively large contribution to growth in the economy last year, as the economy recovered from the pandemic.

A key issue for further development in the economy is how tightly the competitiveness issues in the exporting sector will restrict growth, as production becomes more expensive.

High energy prices no longer main driver of inflation

Inflation has so far mainly been driven by the sharp rise in energy prices, but these have fallen recently, and are in fact no longer the main driver of inflation.

The growth in profits does not, however, lag far behind that experienced with wages, meaning that production costs in Estonia have gone up a long way, potentially threatening competitiveness and economic growth in the future.

More detailed data on manufacturing companies show that manufacturing has influenced the economy most via a decline in wood processing and related branches.

Options for importing wood have been curtailed at the same time that demand has changed in external markets.

Meanwhile, higher interest rates are stifling development in construction, where demand has also fallen for certain products that became popular during the pandemic. Branches of manufacturing that are doing better then that are mainly related to electronics.

Ultimately, indicators for the business cycle show the economy is performing at close to its historical average despite the contraction.

Corporate surveys show that labor shortages were still a serious problem for firms quite recently, though they have now receded to their historical average level.

At the end of 2021, 37 percent of manufacturing companies found that a shortage in labor was their greatest issue, while a quarter of companies in services felt the same way.

This figure had however fallen for both manufacturing and services companies, to an average of 16 percent, as of early 2023.

Similarly, manufacturing companies' production capacity got utilized intensively at the end of 2021, but that indicator is now at a level that would suggest stable growth.

This all indicates that while business activity has clearly declined, the earlier level hinted more at the economy overheating, the central bank says.

Ultimately, while the current state of the economy is weaker than earlier, it is still at around its historical average, demonstrated by unemployment figures, which the labor force survey in the fourth quarter found to be still relatively low, the Bank of Estonia notes.

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