Slow decline in high unemployment
Latvia will meet criteria to enter euro zone
The export-driven slowdown in the Baltic countries is being softened by continued decent domestic demand. GDP growth − which has fallen sharply, especially in Estonia but also in Lithuania − will gradually recover in 2013, sustained by growing private consumption and capital spending. Our GDP forecasts for 2012 (Estonia’s and Lithuania’s also for 2013) are somewhat higher than in May’s Nordic Outlook, where we foresaw upside risks because of domestic demand. But not until 2014 will GDP growth reach its potential pace of 4.0- 4.5 per cent. This means that high unemployment will shrink slowly. Inflation will remain low in Latvia and Lithuania but relatively high in Estonia, where the impact of wages and later also money supply will be larger.
The 2010-2011 export boom helped the Baltics to get back on their feet after their depression. Exports were further stimulated by pay cuts totalling 12 per cent in Estonia and Lithuania and 19 per cent in Latvia. This repaired Baltic competitiveness, which had been undermined by previous overheating. In the past year, however, export growth − which had peaked at 50-70 per cent in current prices − rapidly faded. Last spring, highly export-dependent Estonia and Lithuania reported negative export growth, though partly as a result of base effects and in Lithuania’s case also a planned production hiatus at the country’s export-heavy oil refinery. We predict continued weak Baltic export growth next year, followed by a rebound in 2014 as external demand normalises.
In the past 2-3 years, all three countries have regained lost export market shares; Lithuania and Estonia have reported large additional net market share gains. We believe that the competitiveness of Baltic exports remains good, but with certain warning signs in Estonia. In the past two years, real effective exchange rates (measured by CPI) have appreciated by a mere 1-2 per cent after depreciation during 2009-2010 of about 5-10 per cent (largest in Latvia). This is partly due to the falling euro and because wages and salaries have increased at a modest pace and have not led to any major cost surge. But Estonia diverges, with relatively high pay growth (Q1: +6.9 per cent year-on-year) despite still significant slack in the overall economy. If this pay growth accelerates further, Estonia risks higher cost pressure and renewed competitiveness problems.
Domestic demand is resilient to the export slump. Household confidence has improved this year despite weaker exports, for example. Private consumption and capital spending have driven GDP growth since 2011 and will do so in the coming year as well, but levels remain depressed after the crisis. Capital spending will benefit from increasing construction activity and later also recovery in still-cool housing markets. The Baltics will also use more EU funds for infrastructure projects. Consumption will be fuelled by rising household income and gradual labour market improvement, although this will slow a bit in the coming year. But it will take another 1-2 years before credit expansion becomes a positive growth driver. Although demand for loans has increased somewhat, private sector deleveraging is expected to continue for a while.
Exceptionally large current account deficits during the years of overheating were quickly replaced by surpluses in 2009- 2010 as well as part of 2011. The reasons were improved trade balance and initially also changes in the earnings of foreignowned banks. This year, weakened exports have pushed the Baltic economies back into current account deficits. In the wake of gradual increasing domestic demand, we expect increasing current account deficits over the next couple of years, but the levels will be modest and will thus pose no threat to financing or economic stability.
Unemployment is shrinking from high levels, but only sluggishly in Latvia and Lithuania. Estonia’s faster job downturn is now decelerating abruptly due to the decline in growth. The downturn in unemployment is also partly an effect of largescale emigration. When the Baltics joined the EU in 2004, there was a wave of emigration, since many people sought jobs abroad. The latest deep crisis started a second wave. The negative demographic trend will pose a serious threat to economic growth capacity ahead. The three countries are also struggling with other significant structural challenges, including a combination of high youth and chronic unemployment while some sectors have bottleneck problems.
Estonia: Big export sector having an impact
Estonia is showing a dramatic downshift in growth. During the first three quarters of 2011 there was stable GDP growth, averaging about 8.5 per cent year-on-year − the fastest of all EU countries. In the subsequent fourth quarter, growth was halved. After that, the deceleration continued to 2.0 per cent in the second quarter of 2012. Estonia’s large export sector (equivalent to about 75 per cent of GDP) turned from an advantage to a disadvantage as demand mainly in Western Europe, with Sweden and Finland as the biggest markets, lost momentum. The decline in growth essentially follows our earlier forecasts. Domestic demand is somewhat better than expected. Among other things, public sector construction is strengthening more than anticipated, since the government has used its revenue from the sale of emission allowances. This effect will essentially end in 2013, however. We expect GDP to increase by 2.0 per cent this year, by 3.0 per cent in 2013 and 4.9 per cent in 2014.
Inflation has eased marginally since spring and was 4.1 per cent year-on-year in July. Inflation will remain at this relatively high level this year and next, partly due to comparatively high pay growth. Not until 2014 will inflation slow to 3.3 per cent.
Latvia: Mild slowdown before adopting euro
Latvia’s lower relative exports than Estonia and Lithuania have helped make its economic slowdown gentler. Growth fell from 6.9 per cent year-on-year in the first quarter to 5.1 per cent in the second quarter. Economic deceleration will continue in the second half, when Latvia’s so far fairly resilient exports are expected to drop and the euro zone crisis may generate uncertainty among consumers and investors. Meanwhile trade with Russia will provide some support and in the short term there is capital spending momentum, including some partly EUfinanced investments. We believe that GDP growth in 2012 will reach 3.5 per cent, a bigger upward adjustment of our forecast (by 1 percentage point) than in Estonia and Lithuania. There is also a certain upside risk. Then growth will strengthen gradually to 4.0 per cent in 2013 and 4.5 per cent in 2014. This scenario assumes that capital spending will receive an extra push in the run-up to euro zone accession.
Inflation has fallen continuously in the past year from about 4.5 per cent to 1.9 per cent in July. Weak pay growth and calmer energy prices partly explain this downturn, and in July the VAT cut from 22 to 21 per cent also contributed. Weak underlying price pressure and large idle resources point towards continued low price increases, Higher food prices, due to commodity effects, pose an upside risk in the short term. Inflation will average 2.1 per cent in 2013 and 3.0 per cent in 2014.
We still believe that Latvia will meet the Maastricht criteria in the evaluation of its euro zone application that the EU and ECB is expected to carry out next spring. Inflation will be low enough (no more than 1.5 per cent above the three EU countries with lowest inflation, based on averages for the 12 months before the evaluation), while unexpectedly good growth and continued fiscal austerity this year will push the budget deficit below the 3 per cent of GDP threshold, probably approaching 2 per cent. Latvia can thus probably convert to the euro in 2014 as the government has planned. But this assumes that the EU side does not throw any obstacles in the way; Latvia must also receive EU certification that the downshift in inflation and the deficit can be viewed as lasting.
Lithuania: Falling growth, uncertain election
Lithuania has seen a continuous decline from 6.7 per cent year-on-year growth in the third quarter of 2011 to only 2.1 per cent in the second quarter. The latest quarterly figure was extra depressed by an oil refinery shutdown. Other industrial activity maintained a relatively healthy pace. Consumption growth slowed a bit, while capital spending was sluggish. Yet GDP growth has been somewhat higher than expected. The second half of 2012 will be partly sustained by rebounding oil output. GDP will rise by 3.5 per cent in 2012. In 2013 and 2014 we expect broad-based growth of 4.0 per cent annually. Inflation will climb marginally to 3.0 per cent annually in 2013-2014.
As in Latvia, the government is aiming at euro zone accession in 2014. The inflation criterion may be within reach, though Latvia is in far better shape − looking only at the past year’s performance. Despite fiscal tightening, it may be tricky to achieve a budget deficit of 3 per cent of GDP in 2012. A change of government is also probable after the October parliamentary election. At present it is difficult to predict the political direction and economic policy priorities of the government. In other words, the euro zone issue involves both economic and political uncertainties. As previously, we believe that Lithuania will join the euro zone in 2015.
Nordic Outlook published by SEB Economic Research is available at: www.seb.se