Economic analysis from the European Commission s Directorate-General for Economic and Financial Affairs

Transcription

1 Economic analysis from the European Commission s Directorate-General for Economic and Financial Affairs Volume VII, Issue ECFIN COUNTRY FOCUS Highlights in this issue: Wages and workforce adjusments are restoring costcompetitiveness and productivity in a more flexible labour market The structure of external trade is evolving towards more high-andmedium tech exports Estonia would benefit from reducing the total tax wedge on labour as well as from fostering access to long term risk capital Estonia: towards a swift current account rebalancing By Baudouin Lamine* Summary In a recent past, the Estonian economy registered growth beyond potential, supported by massive financial flows from abroad. As macroeconomic imbalances appeared unsustainable, Estonia's central bank and commercial banks tightened credit conditions, while interest rates rose, contracting thereby domestic demand and inducing an abrupt end to the economic cycle. In 28-29, as the global financial crisis reinforced the deleveraging process, both domestic and external demand contracted, with the resulting fall in imports stronger than the fall in exports and a rapid reversal of the current account, from huge deficits to sizeable surpluses. Since then, wages and workforce adjustments in a quite flexible labour market contribute to restoring cost-competitiveness and to maintaining external surpluses. Moreover, the structure of Estonia's external trade is evolving rapidly towards higher value-added exports. This is progressively offsetting the loss in costcompetitiveness registered by labour intensive exports in the past booming period. Nevertheless, when domestic demand growth eventually resumes, imports should pick up again. At that time the current account balance is likely to shift back into deficit, with a speed and extent less dramatic than in the previous cycle, but still dependent on Estonia's further efforts to increase productivity and competitiveness. Introduction The current account turned into surplus in 29, but is expected to revert to slightly negative figures in the medium term This Country Focus attempts to highlight the most important drivers of the swift current account rebalancing which is taking place in Estonia, and tries to consider the possible way forward for ensuring external sustainability is safeguarded once domestic demand growth will resume. In 25-27, Estonia experienced a credit and real-estate investment bubble, induced by loose monetary conditions worldwide, rapid financial integration of the country in the Nordic banking system and massive financial flows (both credit and FDIs) from abroad. At that time, optimistic expectations about future income, as wages strongly increased, further boosted domestic demand. As a result, GDP growth exceeded potential, leading to accelerating inflation and widening already large external deficits. In late 26 early 27, interest rates rose and, as macroeconomic imbalances appeared excessive and Estonia's central bank and commercial banks tightened credit conditions, the cycle went into reverse. The slowdown was aggravated by the global financial crisis and resulted into an abrupt GDP contraction of nearly 18% over the period A consequence of this was that internal and external imbalances unwound rapidly: HICP annual inflation reached negative territory in June 29, while the current account deficit shrank by nearly 5% in 28 (from 18% of GDP in 27) and has turned into surpluses since spring 29. The current account is expected to remain in surplus, in annual terms, in 21, before possibly reverting to slightly negative figures in 211 or in 212. * Directorate for the Economies of the Member States. The views expressed in the ECFIN Country Focus belong to the authors only and do not necessarily correspond to those of the Directorate-General for Economic and Financial Affairs or the European Commission.

2 Domestic demand growth reached record levels and resulted in exceptional goods imports and huge current account deficits Net FDI inflows strongly increased, while huge credit inflows poured into the economy Factors which contributed to past current account deficits Over the period, investment and private consumption largely contributed to the high rate of GDP growth registered in those years (Chart 1). Increases in inventories were also considerable. This pushed up domestic demand to 112% of GDP in 27. It also fostered goods imports averaging over 7% of GDP from 25 to 27, pushing current account deficits to around 18% of GDP in 27 (see Chart 2), even though such deficits also reflected the contribution of higher net income outflows from foreign-owned investments (exceeding 5% of GDP in most years). The financial outflow related to higher imports (Chart 3) was partly offset by considerable foreign capital investment, in the form of FDIs (Chart 4) or net credit flows (see Chart 5). The domestic shortages created a situation of overheating characterised by rising inflation rates and wage growth rates exceeding productivity growth. This reduced cost competitiveness (Chart 6) and affected goods exports in low-skilled sectors of the economy. External gross debt also rapidly increased, exceeding 11% of GDP in 27. Chart 1: Contributions to GDP growth at constant prices Contrib. of the balance of goods & services Contribution of changes in inventories Contrib. of gross fixed capital formation Contribution of public consumption Contribution of private consumption Chart 2: Current account balance (as a % of GDP at current prices) Net exports - Goods Net exports - Services Net primary income Net current transfers Current account Source: AMECO Commission Services and AMECO Commission Services Chart 3: Total imports of goods Total exports of goods (in ) 14 Chart 4: International Investment position FDIs net (as a % of GDP at current prices) 8% Total imports of goods Total exports of goods 7% 6% 5% 4% 3% 2% 1% Source: AMECO Commission Services % Total FDIs net Denmark Finland Norway Sweden Effects of the current downturn From early 27, foreign banks reassessed their risks upwards, while, from 28, the global financial crisis reinforced the deleveraging process Already since late 26-early 27, action was taken to counter the overheating. Nordic banks reassessed the risks stemming from their growing exposure in the Baltic States and from Estonia's growing internal and external imbalances, and progressively tightened their lending conditions. In the meantime, interest rates started rising (Chart 7) and prudential rules set by the Estonian central bank were tightened. As a result, credit growth rapidly slowed down and eventually turned negative (yoy) in 28, down from an annual average growth of nearly 7% to households and commercial undertakings over the period (Chart 8). In parallel, the global financial crisis reinforced the deleveraging process, with the marked deterioration in global and regional trade hitting Estonia hard due to the openness of its economy. Competitiveness was further challenged by nominal depreciations in important trade partner countries (Sweden, Russia). Both domestic demand and external demand were therefore negatively affected, reducing both imports and exports dramatically (see Chart 3). However, the fall in ECFIN Country Focus Volume VII, Issue 6 Page 2

3 imports was substantially stronger than the reduction in exports. As a result, the current account deficit nearly halved in 28, compared to 27, and has registered comfortable surpluses since 29Q2. While services registered continuous surpluses, trade balance reverted to positive numbers. A rapid decline in income outflows on foreign-owned businesses in Estonia as well as a sharp reduction in direct investment (including reinvested earnings) (see Charts 2 & 4) reinforced the rapid reversal. At the same time, access to credit became difficult in certain sectors. Chart 5: International Investment position Chart 6: REER 1 Share of exports of Other investment net (as a % of GDP at goods in world exports current prices) % -1% -2% -3% -4% -5% -6% -7% -8% 23 Total other investment net Denmark Finland Norway Sweden Chart 7: Weighted average annual interest rates of EUR and kroon loans 14.% 12.% 1.% 8.% 6.% 4.% REER (DPC) (lhs) REER (exp. pr. defl.) (lhs) Share of exports of goods in wrld exp. (rhs) REER (GDP defl.) (lhs) REER (ULC tot. econ.) (lhs) Source: AMECO Commission Services Chart 8: Loans granted by groups of customers (as a % of GDP - ls) and annual growth (% - rs) 8.% 7.% 6.% 5.% 4.% 3.% 25 Commercial undertakings (ls) Individuals (ls) Commercial undertakings (rs) Individuals (rs) % 5.%.% -5.% 2.% 2.% -1.%.% Weighted average annual interest rates of EUR denominated loans (most of the loans granted) Weighted average annual interest rates of kroon loans 1.%.% % Expected developments once growth recovers in the medium term Domestic demand will remain subdued in 21, while external demand is recovering Negative wage growth and labour shedding are restoring productivity and cost competitiveness, in a more flexible labour market Domestic demand fell in 29 and is likely to fall also in 21: high unemployment (18.9% for category in 21Q2) as well as negative wage growth (Chart 9) are expected to further depress private consumption, while the sharp drop in capacity utilisation could limit investment. However, Estonia should be able to benefit relatively quickly from the rebound of the world economy, and particularly of its main export markets (see Chart 1). This would be more likely, if, thanks to its relatively high labour market flexibility, the ongoing wage adjustment fully reverses the earlier fall in competitiveness. Cost competitiveness (Charts 6 & 9) and labour productivity are supported by a significant wage adjustment (-4.8% yoy on average in the manufacturing sector in 29) and labour shedding, mainly in the previously overheated sectors, but also in manufacturing. Annual HICP inflation, although turning positive in March 21 and increasing in recent months, is expected to remain moderate in the next coming years. The flexibility of the labour market, recently reinforced by the adoption of a modernised Labour Law, is moreover expected to facilitate the necessary transfer of resources from the non-tradable to the tradable sector. Nevertheless, a more immediate concern is that unemployment is still high, despite sustained job creation and increasing vacancies. 2 Finally, the ongoing recovery of the global economy is expected to translate into better export figures, allowing thereby Estonia s own recovery to get off the ground. However, when domestic demand growth eventually resumes, the current account ECFIN Country Focus Volume VII, Issue 6 Page 3

4 balance may shift back into deficit, since imports will likely be growing again stronger than exports, despite Estonia's relatively good export potential. The speed and extent, however, should be less dramatic than in the previous cycle, but will be dependent on Estonia's continued efforts to increase productivity and competitiveness. Chart 9: Growth of average hourly gross wages and salaries (yoy) 35% 3% 25% 2% 15% 1% 5% % Economic activities total -5% Manufacturing -1% Construction Public administration and defence; compulsory social security -15% -2% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q Source: Statistics Estonia Chart 1: GDP growth (incl. GDP forecasts) of Estonia's main export markets 15.% 1.% 5.%.% -5.% -1.% -15.% -2.% DE LV LT FI SE UK Sources AMECO Commission Services Sub-sectors that could form the basis of a future recovery Medium-to-high technology exports have become the most dynamic category Exports of services are growing rapidly Estonia has been climbing the technology ladder from low tech (LT) exports in the late nineties to MLT exports in this decade. This phenomenon reflects the progressive evolution of Estonia's labour skills and cost-competitiveness conditions. The current dynamism of MHT exports augurs relatively well for future trade developments. A close look at sub-sectors that could form the basis of an export recovery (Chart 11) indeed indicates that, in the period, medium-to-high tech (MHT) exports were predominant among most dynamic exports (export categories representing a minimum share of total exports and registering a continuous and sizeable expansion over the period considered) and registered a sharp increase in total value. MHT exports appear therefore to have the highest export growth potential. However, the development of genuine HT exports in a broader product range than in the late nineties might be a longer term prospect, notwithstanding the improved raking of Estonia in the European Innovation Scoreboard Chart 11: Distribution of "most dynamics exports" by technology level over the and periods 5% 45% 4% 35% 3% 25% 2% 15% 1% 5% % period period HT products MHT products MLT products LT products ICT products (largely overlapping HT products) Source: author's calculations In 27, more than half of Estonia s exports still consisted of raw materials or labourintensive products, with raw materials clearly dominating (a third of the total). However, the share of labour-intensive exports continued its decline after a peak in 24, while the shares of capital-intensive products and (difficult to imitate) researchintensive exports grew rapidly (see Chart 12) over Overall, Estonia seems to have a relatively sophisticated export basket, but where the price per unit paid for exports from Estonia is still lower than prices on the world markets. Estonia appears therefore to have room to upgrade quality and capture more markets in existing products. The country also seems to have the potential to move to new products, as many closely related export activities are expected to emerge over time, thanks to relatively well connected industrial activities or "clusters". 4 With respect to services, most sectors are growing rapidly, in particular exports of other business services, as well as of computer and communications services. In the booming period, exports of financial services, as well as of construction services to neighbouring Finland, also developed markedly, but significantly declined during ECFIN Country Focus Volume VII, Issue 6 Page 4

5 Policies aimed at promoting R&D and innovation should be continued, as well as policies ensuring that labour skills match evolving market needs the global crisis.(see Chart 13). In 29, travel and transportation remained the most important services sectors, together reflecting a share of more than 6% in services exports (8% in 2) and of 2% in total exports (25% in 2). Their potential is still significant, despite regional political tensions and the development of competing Russian ports on the Baltic Sea. Chart 12: Total value of exported products - Distribution by factor intensity 35.% 3.% 25.% 2.% 15.% 1.% 5.%.% RMIG: raw material CIG: capital intensive DIRG: difficult to imitate technological products EIRG: easy to imitate technological products LIG: labour intensive products Chart 13: Total value of exported services - Distribution by main categories (mln ) Transportation Travel Communication Construction 2 29 Insurance Financial serv. Computer services Royalties Other business serv. Personal serv. Government serv. Source: author's calculations The way forward What are the perspectives for the current account over the next few years? The REER assessment (Chart 6) suggests that Estonia's cost competitiveness deteriorated during the overheating period. However, Estonia's imbalances originated mostly from a too rapid growth of imports (see Chart 3), fuelled by excessive credit growth (see Chart 8) in the later phase of the cycle, and probably less so from a deterioration in the country's export performance. While Estonia's imbalances mostly originated from excessive credit growth, the necessary deleveraging process is ongoing, and exports perspectives are good Increasing productivity and competitiveness is paramount, but labour market efficiency is improving and the necessary adjustment is taking place As regards credit flows, deleveraging is ongoing, reducing domestic demand and, thereby, excessive imports. This may lead to a more balanced credit growth over time: contrary to the past where banks mostly financed real estate and construction, they seem now more interested in financing viable projects in the tradable sector, supporting thereby higher exports prospects. In addition, the current governmentsponsored programmes aimed at supporting exporting enterprises, in particular through an efficient use of EU structural funds, should foster the ongoing economic rebalancing. Finally, a law establishing a state-owned insurance company aiming exclusively at supporting exporting companies was adopted in late 29, with the company expected to become fully operational very soon. In Estonia's process of euro adoption on 1 January 211, reserve requirements for banks are progressively being aligned with ECB's monetary policy decisions: reserve requirements have been reduced (from 15%) to 11% of the reserve requirement calculation basis as from 1 September 21 and will be at 7% as from 1 November. Further raising competitiveness and productivity However, as the fall in imports will likely disappear, putting pressure on the external balance, the need to increase productivity and competitiveness will once again become paramount. This can be achieved through cost reductions and, with effects more in the longer run, by productivity increases. With respect to cost reductions, wage adjustment is taking place and is expected to have continued in 21. A new Labour Law (entered into force on 1 July 29) has further reinforced the flexibility of the labour market, in particular through reduced administrative interferences, lower firing costs and increased possibilities of employment contracts with limited duration. 5-6 In parallel, the merger of the Labour Market Board and the Unemployment Insurance Fund on 1 May 29 seems to be resulting in increased labour market efficiency, in particular through a close cooperation between employers and unions. The new body appears to be intensifying job intermediation: with respect to the unemployed, the number of deregistration because of becoming employed was higher in 29 than in any other year since 23. Estonia is also progressing towards a more cost-effective and flexible public service. However, several professional services remain regulated, energy intensity remains high, as well as usage fees of ICT networks. Regarding productivity, domestic enterprises are mostly SMEs and their capacity to invest in R&D is therefore limited. This partly explains why Estonia's patent and ECFIN Country Focus Volume VII, Issue 6 Page 5

6 Responsible fiscal policies have been a major element of the good climate for business Consideration should be given to reducing the total tax wedge on labour, while raising alternative revenues Access to longterm risk capital should be fostered trademark application rates are still rather low. Therefore, public policies aimed at promoting R&D as well as innovation, primarily private, could be reinforced. This should ensure that Estonia continues to climb the technological ladder and progressively shifts to a predominance of medium-to-high tech exports. Finally, ensuring that labour skills match the evolving market needs is essential to reaching the objective of higher tech exports. Estonia's education system combines both quality and equity, and is rated above the EU average. Nevertheless, raising labour skills further, by making training systems more responsive to labour market needs and investing in life-long learning, would support the ongoing shift to more sophisticated exports. Infrastructure, including cross-border and ICT infrastructure, could be reinforced to facilitate access and mobility, fostering thereby investment and growth. A continued responsible and attractive fiscal policy The restrictive budget policies implemented in recent years, including the efforts to limit budget deficits to 3% of GDP, as well as to revert to a balanced budget as soon as the crisis is over, have strengthened the sustainability of public finances. Estonia's general government debt burden will remain the lowest in the EU for many years to come. Jointly with euro adoption, sound budgetary policies make the country attractive to long-term investment, which in turn will foster technological progress. This prudent fiscal policy has been one of the major elements of macroeconomic policy differentiating Estonia from its Baltic neighbours, Latvia and Lithuania, during the last decade. The recent change to the taxation framework for foreign-owned companies (removal of withholding tax from 1 January 29) further reinforces the already highly favourable climate for inward investment. Further improvement in the structure of the budget may help the country to avoid the re-emergence of fiscal deterioration. The current "balance or better" fiscal rule could not prevent a surge in spending during the boom years, while tax revenue was excessively cyclical, leading to a rapid worsening of the fiscal balance when revenues shrank during the downturn. Overall, tax revenue appeared insufficiently diversified and policies more directed at fostering growth, than at stabilizing the economy. The Estonian authorities have already announced that they will conduct a detailed analysis of the economic and budgetary impact of alternative fiscal options. At that time, and provided economic recovery has started, consideration could be given to reducing the total tax wedge on labour, which is relatively high by OECD standards (notably social contributions), while raising alternative and non-distortive revenue sources. This could include extending the tax base to real estate 7 and vehicle motor taxation. Other progress While, over time, investment is expected to resume, it is also vital that it takes place in the tradable sectors, supporting the progressive reallocation of resources from the non-tradable sector. In this respect, a recent amendment to the Income Tax Act 8 (entering into force on 1 January 211) should contribute to ensuring that counterparts to increased capital formation include sufficient equity capital, and that investment takes place in the right (tradable) sectors. References Brixiova Z., Vartia L. and Wörgötter A. (29), Capital inflows, household debt and the boom-bust cycle in Estonia, Economics Department Working Papers, N 7, OECD, Paris, May 29. IMF (21), Staff Report for the 29 Article IV Consultation, International Monetary Fund, Washington, January 21. European Commission (21), Public Finances in EMU 21, European Economy n 4, Department of Economic and Financial Affairs, Brussels, 21. Lamine B. (28), Estonia: overheating and sectoral dynamics, ECFIN Country Focus Volume 5 Issue 7, Directorate-General for Economic and Financial Affairs, European Commission, Brussels, August 28. Lamine B. (29), Estonia: analysis of a housing boom, ECFIN Country Focus Volume 6 Issue 7, Directorate-General for Economic and Financial Affairs, European Commission, Brussels, July 29. OECD (29), 29 OECD Country Economic Survey Estonia, Paris, 29.World Bank (27), Credit expansion in emerging Europe: a cause of concern, World Bank EU8+2, Regular Economic Report, Part II: special topic, Washington, January Based on deflator for private consumption, GDP deflator, export price deflator and ULC (tot. econ.) vs 35 industrial countries. Despite the fact that Estonia's economy has already bottomed out. Unemployment is indeed a lagging cyclical indicator. ECFIN Country Focus Volume VII, Issue 6 Page 6

7 A successful HT episode in the late nineties was made possible by specific sub-contracting arrangements on low valueadded operations and by exceptional cost-competitiveness conditions which have now disappeared. In the European Innovation Scoreboard 29, Estonia ranked 11 th in the EU. EBRD Transition Report of 28. Unemployment benefit increases and enlarged scope for unemployment benefit entitlement, initially scheduled for mid- 29, have been postponed until 213, owing to obvious budgetary constraints. With respect to active labour market policies, particularly important in a situation of protracted recession, legislation appears flexible enough to provide measures preventing structural unemployment from becoming embedded, while previously low budgets for such measures have been increased and scheme participation rates are increasing. See Lamine B. (29). The new Act will enter into force on 1 January 211. It establishes a system of investment account allowing the income earned from investments in securities by natural persons to be treated similarly for taxation purposes (tax exemption for non-distributed profits) to the income earned by legal entities. The ECFIN Country Focus provides concise analysis of a policy-relevant economic question for one or more of the EU Member States. Chief Editors: Jürgen Kröger, Matthias Mors, Istvan Szekely, Directors Economic and Financial Affairs Coordinating Committee: Laura Bardone, Heinz Jansen, Mary McCarthy, Javier Yaniz Igal Layout: Yves Bouquiaux, Fabrizio Melcarne ECFIN-CountryFocus@cec.eu.int Website: ECFIN Country Focus Volume VII, Issue 6 Page 7