Bank of Estonia's second quarter (Q2) economic forecast, which was published on Tuesday, shows that the overall situation of the Estonian economy is satisfactory. However, the situation varies from sector to sector due to the differing impact of recent crises.

The picture also differs depending on whether the impact of price increases is taken into account when calculating economic growth. When measured in euros (GDP at current prices), the Estonian economy can be seen to have grown by almost 30 percent in two years. However, in real terms (GDP at constant prices), the Estonian economy has been steadily shrinking for more than a year.

While a recession normally leads to higher unemployment and slower wage growth, so far the Estonian labor market has proved resilient, with unemployment close to 5 percent and wage growth above 10 percent.

The recession has had relatively little impact on the labor market up to now as in many sectors companies' turnover and profits have risen faster than the cost of wages. The manufacturing and construction sectors have been hit hardest, with employment falling. Meanwhile employment in the public and private services sectors has increased, Bank of Estonia said.

The central bank expects economic growth to recover in the second half of 2023.

In the first half of the year, private consumption was subdued as consumption fell from last year's unsustainably high level. These were reached in large part due to the use of pandemic and pension savings.

Going forward, consumption growth is likely to pick up as purchasing power also improves.

Average wage purchasing power, which declined in 2021 and began rising again last year, will recover in 2024 and continue to strengthen in 2025.

The economy's growth prospects will also be supported by rising demand in key export markets and lower cost pressures on export prices resulting from the easing of the energy crisis.

Although the Estonian economy will improve over the year, this comes on the back of five straight quarters of contractions, leaving the economy one percentage point smaller than at the same stage last year. Growth is expected to pick up in 2024 however, and reach over three percent by 2025.

Price growth will continue to slow

Inflation reached close to 11 percent in May, mostly reflecting the surge in prices, which occurred in the first half of last year. At the same time, the average cost of consumers' weekly shopping baskets has risen by around four percent in the past nine months. However, price increases will continue to stabilize and slow to around five percent by the end of this year, remaining at an annual average of one percent.

The new VAT increases will provide a one-off boost to prices, the effect of which will mainly be seen in 2024. The average price increase next year will be close to four percent, before falling to 2.5 per cent in 2025. The slowdown will be driven by lower energy costs, which will gradually be passed on to food commodity and retail prices.

Developments in Russia's war in Ukraine may also have an impact on commodity market prices.

Although forward transactions in various energy commodities are expected to maintain much lower price levels than last year, there still remains a risk of unexpected energy price increases due to changes in supply chains.

Interest rate increases introduced by the European Central Bank (ECB) to curb inflation are also pushing up the cost of borrowing for individuals and businesses in Estonia.

The additional interest costs for companies come to around 10 percent of profits, while for households they amount to less than 2 percent of consumption expenditure.

By comparison, a continuation of rapid price rises would have a much more damaging effect, both on people's purchasing power and the economy more generally.

According to recent business survey data, economic growth is not being held back by financing conditions, but rather the lack of demand, which is linked to the decline in purchasing power. The very low proportion of non-performing loans is a further indication of the ability to cope with borrowing commitments.

Bank of Estonia expects fiscal deficit to rise sharply this year.

The bank forecasts a slow-down in revenue growth, while expenditure growth is expected to accelerate, due to surges, both social transfers and the wage bill for government employees.

Last year's deficit was smaller as a result of tax receipts rising in line with the rapid price increases and due to some cuts to planned public spending.

The implementation of all the fiscal policy changes envisaged by the government is expected to lead to temporarily increased prices. However, this will also reduce the need for sustained price rises in the longer term.

According to Bank of Estonia, it is necessary to reduce the budget deficit, which has become permanent, as this would help curb the rapid price increases.

It would also help to avoid a further increase in Estonia's public debt and the resulting interest costs.

This will however provide a greater challenge in the future, as pressures to increase current expenditure (including social and health care expenditure and security) intensify over time and the proportion of Estonia's working-age population also declines.

In the longer term, sound public finances and a low debt burden will underpin Estonia's competitiveness and growth capacity.

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