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Bank of Estonia: Drop in competitiveness suggesting trouble ahead

Bank of Estonia Governor Ardo Hansson.
Bank of Estonia Governor Ardo Hansson. Source: (Siim Lõvi/ERR)

The Bank of Estonia expects the Estonian economy to grow by 3.5% this year and next, but says that growth will slow after that, coming in at close to 2% by 2020. One reason is that fewer people are entering the labour market, another that the competitiveness of Estonian companies is declining.

The growth in labour costs in Estonia has been among the fastest in Europe, which has hindered the export of Estonian products, as prices for Estonian exports are rising faster than those of competing products. The share held by Estonian exports in the markets of Estonia's main trading partners first started to shrink in 2017, while the economies of those countries were doing exceptionally well and growth was fast.

Labour shortages are causing wages to keep rising in Estonia, which is making production ever more expensive. As the full impact of rising wages is only felt after some years, the deterioration in competitiveness "casts a shadow over the years ahead," the Bank of Estonia wrote on Wednesday.

Governor Ardo Hansson sees the Estonian economy potentially in trouble: "We face the genuine danger of ending up in a similar situation to that of Finland a few years ago. The economy there cooled while wages continued to increase quickly. This reduced the competitiveness of exports, after which there was a recession that lasted several years. The example of Finland shows that the consequences for the economy of shrinking competitiveness can linger for years, during which time people's incomes don't rise," Mr Hansson said.

Rapidly rising wages will force Estonia to abandon low-productivity manufacturing, the bank wrote. Estonia's issue here is that compared to Latvia and Lithuania, a relatively larger share of the workforce is employed in manufacturing, and productivity is lower in that sector than in other branches of the economy.

This means that there is still quite a lot of low-productivity production in Estonia, which will be forced to close down if labour costs continue to rise over the coming years. The industrial sectors with low productivity have already lost workers, and this trend is likely to continue. The movement of workers to jobs of higher productivity will overall have a beneficial effect on the economy, though the economy as a whole would suffer from a climb in wages as long as the main movement is purely towards jobs with higher wages, but competitiveness lagging behind.

Inflation is dropping in Estonia, mainly because of taxes and energy. It peaked in 2018 and from 2019 onwards will come down to close to 2%, the Bank of Estonia expects.

Although the peak of the economic growth cycle has been passed, the tight labour supply will keep up wage growth and boost prices of services in particular and also those of goods. Equally, the substantial impact on overall inflation seen in earlier years from tax increases will fade, and higher energy prices won't affect the cost of the consumer basket as much as before, the bank said.

Despite slower growth tax receipts in Estonia will be higher than usual, and so it would be reasonable for the government to plan its spending up to 2021 with a surplus in the budget. This would allow reserves to be built up during the good times that could be used to stoke the Estonian economy during the downswing of the economic cycle, the bank recommended.

Editor: Dario Cavegn

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