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Bank of Estonia: Recession to continue and unemployment to rise

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The Bank of Estonia (Eesti Pank) building in Tallinn.
The Bank of Estonia (Eesti Pank) building in Tallinn. Source: Siim Lõvi/ERR

Bank of Estonia (Eesti Pank) has adjusted its economic forecast for next year and now says the recession in Estonia will continue. The central bank also expects unemployment to rise and tax revenue growth to slow significantly. The situation is only likely to improve once the economies of the Scandinavian countries start to grow.

Bank of Estonia has adjusted its forecast for economic contraction this year by 1.3 percentage points to 3.5 percent. While in its September forecast, the central bank expected Estonia's economy to grow next year, it now expects a contraction of 0.4 percent - 1.8 percentage points less than in September.

"The state of the economy is worse than we ourselves thought a few months ago," vice president of Bank of Estonia Ülo Kaasik said at a press conference to introduce the economic forecast. "This also makes people's lives more difficult."

According to Bank of Estonia, the past year has turned out to be more difficult than expected for the Estonian economy, and the recession will last longer than previously forecast. Sales opportunities for companies on the domestic market have been constrained by people's uncertainty about the future, as well as the resulting increase in savings.

Exports in decline

However, sales to external markets have been hampered by the poorer performance of Estonia's main export markets in comparison to the European economy as a whole, as well as by the depreciation of the exchange rate with the Nordic countries. Rising production costs and the disruption of several existing supply chains, as well as the disappearance of certain business models as a result of Russia's war in Ukraine  have also played an important role.

"If we look at the target markets to which Estonian exports have mostly gone, then our neighboring countries, our main export markets, are in decline today. Take Sweden, Lithuania, Germany, Latvia for instance. There the economy is set to decline over the coming year, according to a recent forecast by the European Commission," Bank of Estonia (Eesti Pank) economist Rasmus Kattai added. "Our main markets are in worse shape than Europe is as a whole."

According to Kattai, the export of goods will have fallen by a tenth, with a further drop expected in 2024. After that, goods exports could rebound.

While foreign trade is in decline, consumption has also fallen significantly, according to Kattai. On the one hand, people have started saving more, but there has also been a clear increase in purchasing in recent years, despite inflation, Kattai said.

Investments in decline

In addition to increased uncertainty in the economy, the external environment and taxation, business investment has also declined, Kattai said. "Added to this are the effects of higher interest rates, meaning that the cost of money is more expensive, which is partly holding back investment," Kattai said.

"Another aspect that is very important in the shorts term is that, as the economy is in a trough, a relatively large amount of previous investment is sat idle. Before new investments are made on a larger scale, we will probably see a greater deployment of existing capital and equipment," Kattai said.

"This year's annual recession is going to be more widespread than our previous forecast. The economy will contract by 3.5 percent this year. In our latest forecast, we have unfortunately come to the conclusion that the Estonian economy has entered a protracted, relatively long recessionary period, whereby we will experience three consecutive years of contraction," Kattai said.

Unstable conditions and higher interest rates have not been conducive to new investments. Overall, the Estonian economy is set to contract for the second year in a row, with the decline expected to reach 3.5 percent.

Estonia's economy is expected to continue to contract slightly, by 0.4 percent, in 2024, with demand for goods and services only recovering slowly on both domestic and foreign markets. According to the central bank's forecast, there will be opportunities for faster economic growth of close to 3 percent in 2025 and 2026.

Impact of recession to hit labor market

The impact of the recession will be increasingly felt on the labor market. Up to now, companies have largely avoided cutting jobs, which has kept the country's total wage bill at an all-time high, despite almost two years of recession.

"While so far the increase in unemployment has been mainly due to a rise in people's participation in the labor market, rather than a fall in employment, a fall in employment is likely to contribute significantly more in the future," Kattai said.

Retaining workers has been possible due to expectations of a rapid economic recovery and a fall in real wages, making labor cheaper for employers. However, the sharp fall in productivity signals an underutilization of the labor force, and a more pessimistic outlook for the near future will lead to a rise in unemployment levels, which are expected to peak at nine per cent in 2024.

Labor market contraction will depress wage growth. Reduced labor demand and the slowdown in price growth will also have an impact on wage growth. In 2024, collective wage agreements already concluded in the public sector will prevent wages from fully adjusting to the more challenging economic conditions, as will the national minimum wage increase to €820.

In 2024, average wages will increase by 6.6 percent before dropping back to around 5 percent in the following years. The increase of more than 13 percent to the minimum wage, which is due to come into effect next year, is likely to overwhelm many lower productivity and lower-wage firms. Part of the increase in unemployment will be offset by the rising minimum wage.

According to Kattai, one of the reasons why unemployment is expected to rise is Estonia's level of productivity per employee, which has fallen significantly. "The decline in productivity per employee does not show much other than that workers are under-utilized. Companies don't have enough work to give them," said Kattai.

At the same time, Bank of Estonia is certainly not forecasting the kind of increase in unemployment that happened in Estonia during the last financial crisis, when the number of unemployed people rose by more than 100,000. "In this case, we are talking about 10,000 to 15,000 additional job seekers," Kaasik said.

Kattai added that unemployment reaching 10 percent within the next year cannot be ruled out.

Purchasing power continues to improve

People's purchasing power continues to improve. In a little over a year, average wage purchasing power has recovered by around a half. The remaining half will take longer because, although inflation is slowing, future wage growth is also predicted to be more subdued. Purchasing power, which preceded the rapid rise in the cost of living, is likely to recover in 2025.

"The faltering of price growth, along with sustained wage growth, means that people's purchasing power is still continuing on the path to recovery. We've reversed around half of the decline in real wages so far and the remaining half is still to come," said Kattai.

Price growth continues to slow. The cost of the average monthly shopping basket has remained stable for more than half a year, and the current inflation outlook of four to five percent is due to the lower base on year. Next year, VAT and excise duty increases will push prices up, with an average monthly shopping basket expected to rise by 3.4 percent as a result. In 2025 and 2026, price growth is expected to remain slightly above two percent.

Price rises will be curbed by weak economic activity. In some sectors, there are sufficient buffers to allow prices to be lowered due to cheaper energy, commodity prices and profit margins.

Drawing up state budget expected to become even more difficult

"If we have a smaller euro-denominated economy over the coming years, this will of course be reflected in lower tax revenues," Kattai said.

Given the weaker-than-usual economic cycle over the coming years, fiscal support will be necessary to stimulate the economy. At the same time, the budget is already in persistent deficit as a result of past decisions. Due to this,  further stimulus would mean even higher deficits, accelerating the increase in the public debt and interest burden.

"The long-term problems we have in public finances are more persistent and will last longer. In other words, it also means that these decisions are the more painful ones we will have to take if we want to get our budget back to being balanced," Kattai said.

The scope for doing so is also constrained by possible inconsistencies between Estonian national and EU rules. As tax revenue growth is likely to remain below levels projected so far, there is growing pressure to curb expenditure growth or find new sources of revenue in order to avoiding increased debt.

"The greater the deficit we have now and the longer it persists, the greater the burden we place on the future, and the more difficult it will be to make further cuts in the future. Of course, in these extremely difficult economic times, we may not have to rush to make cuts immediately," Kaasik said.


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Editor: Michael Cole

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