In the second quarter of this year turnover dropped and profit growth halted for Estonian companies. The slowdown in economic development, coupled with decreasing inflation, has diminished the ability of businesses to generate profits.

"Many of the prices related to production are already falling, while export prices, for example, have increased to an extremely high level in comparison to other countries in the previous few years," Mertsina said.

"Similarly, the cost of labor to produce unit value added, which is a measure of the price competitiveness of the economy as a whole, has risen more in Estonia than in, say, Latvia, let alone Finland, Sweden and Germany."

Since the second half of 2021, real labor productivity has been declining, as employment and hours worked have remained very high despite a declining gross domestic product (GDP).

"When labor cost growth exceeds productivity growth, a company's competitiveness declines," Mertsina said. "The increase in corporate profits was the major contributor to overall price growth in Estonia during the first phase of the acceleration in inflation, from the second half of 2021 to the beginning of 2022, but labor expenses will play the biggest role this year."

Since more than a year ago, the share of labor costs in the price growth of the total economy has remained relatively high. In the first half of this year, companies have maintained the same level of turnover as last year, while labor costs have risen by 10 percent.

"Although labor cost growth is slowing, it is likely to remain too high relative to companies' turnover in the near term," Mertsina added.

Estonia is struggling with price competition

Estonia's average price level had been gradually approaching that of its main trading partners, but in recent years it has experienced an unusually quick leap.

According to early OECD estimates, the average price level in Estonia is greater than in Latvia and Lithuania, and has already increased to 78 percent of Finnish prices, 86 percent of Swedish prices, and 93 percent of German prices.

"Aside from quick price increases, the price competitiveness of Estonian exports has been affected by the appreciation of the real effective exchange rate in comparison to countries such as Lithuania, Germany, Finland, and, in particular, Sweden, where the currency has weakened dramatically," he said.

Competitiveness is lower

According to Swedbank, Estonian companies' assessment of their competitiveness in both domestic and foreign markets has fallen to its lowest level this century.

Weak external demand affects not only firms that export directly, but also the domestic value chain as a whole, which includes companies that produce products or services for exporters.

"Estonia's corporate taxation falls within the European average," Mertsina said. "So current corporate tax should not diminish Estonia's competitiveness relative to other European countries. However, Estonian businesses face a greater tax burden than their counterparts in Latvia and Lithuania."

The greater the tax burden on businesses, the greater the impact on their competitiveness.

Improving demand is one of the preconditions for enhancing business competitiveness, but businesses must invest more to increase their productivity.

"However, lower demand, falling confidence, and rising interest rates have all curtailed investment," Mertsina said. "Manufacturing investment is also hampered by much reduced capacity utilization. As a result, business investment as a proportion of GDP has fallen substantially below the long-term average this year."

Total economy investment in machinery and equipment, transport and intellectual property-related products accounted for just over a tenth of GDP in the first half of this year. This placed Estonia among the European average.

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