Analytics, Banks, Economics, Estonia, Financial Services

The outlook for the Estonian economy is uncertain though, as the pandemic remains impossible to predict despite the hopeful news about vaccines, and the developments in the economy may differ substantially from expectations.

The economy will contract by 2.5% this year. This is a much softer decline than was feared when the coronavirus crisis erupted, and is also one of the smallest in Europe. The relatively gentle blow means that exiting the crisis will be easier. If vaccination succeeds and the spread of the virus can be brought under control in first half of next year, the economy will start growing again in the second quarter of next year and GDP will grow by 2.9% in 2021.

The rapid bounce back of the economy in the third quarter of this year demonstrated that it is able to grow rapidly once restrictions are removed. If the vaccination puts a stop to the pandemic soon enough, the coronavirus crisis will not have caused lasting harm to the economy, which will return to its growth track that was forecast before the crisis by 2022. Businesses have a lot of resources standing unused and the lending conditions of the banks remain favourable. A broad budget stimulus and the pension savings that can be used for consumption after the elimination of the mandatory second pension pillar will temporarily reinvigorate demand and consequently economic activity during the forecast horizon.

The flexible labour market means that employment has dropped sharply and assistance will need to be directed to the unemployed. Although the recession in Estonia has so far been one of the smallest, employment has fallen further than in most other European countries. The labour market is flexible by international standards and this allowed employment to adjust rapidly to the new circumstances in spring and summer already, evidence for which is that the ending of the wage subsidy was not followed by a wave of redundancies, and the number of redundancies did not rise in October and November either. The unemployment rate will still rise because of the second wave of the virus, and it will peak in early 2021 at a little above 10%, falling back to close to 7% by 2023.

The outlook for the Estonian economy is uncertain. Although news of the vaccine has increased hope of a rapid exit from the crisis, the forecast continues to be surrounded by a great deal of uncertainty because the path of the virus and the restrictions imposed because of it and their impact on the economy can vary widely from expectations. Although the base scenario of the forecast is that the economy will grow by 2.9% next year, the negative scenario is that it could shrink by a further 1.8% next year. The wide spread of these forecasts is closely connected to the outlook for the euro area, where growth in 2021 is forecast to be between 0.4% and 6%. The major lack of clarity about foreign demand makes the outlook for the Estonian economy uncertain as well.

The exit from the crisis can be helped by temporary and well-targeted support measures from the government for people and businesses. It may prove necessary to extend within appropriate limits the support measures taken in the spring, depending on the spread of the virus and on the set of restrictions applied to businesses. As various restrictions that hinder economic activity have been deployed as the first line of defence against the pandemic, then it is appropriate to direct aid to the sectors that have seen their activities most directly limited.

The base scenario finds that the budget will be in deficit even if the economy has returned entirely by 2022 to the level forecast before the crisis. In the most probable forecast scenario, the economy returns in 2022 to the track that was predicted before the crisis. The government will not manage to bring the budget into balance by that time according to the state budget strategy. This means that maintaining the current budget policy will lead the government to increase public debt to cover the cost of its fixed spending and investment even after recovery from the crisis.

A sharp change in budget policy will be needed to stop the unrestrained growth in the national debt. The general government budget was in structural deficit even before the crisis, and the rise in fixed spending driven by social benefits will keep the budget in structural deficit in the years ahead. To stop the national debt growing endlessly, spending by the state will have to grow more slowly than the economy as a whole, or the tax burden will have to be increased.