The main challenge of Latvia, Lithuania and Estonia is small and open economies, so the problems in all three countries are similar. Our economic growth rate will largely depend on the success of our trading partners. There is no “crystal ball” in the economy, but we can analyze what is happening in our neighbors and with our export partners, namely Germany, Sweden and Finland.
According to the data of the Central Statistics Office of Latvia, published last November, from January to September 2023, the share of Latvia’s five largest export partners – Lithuania, Estonia, Germany, Sweden and the Russian Federation – made up 48.7% of the total export value. This is 0.4 percentage points more than in the same period in 2022.
Export-oriented economies are significantly affected by changes in interest rates. Looking at the possible developments of 2024, it can be seen that Europe will face a dilemma whether to start reducing interest rates at the beginning of the year or to leave it for the second half of the year.
This dilemma is caused by relatively high inflation, which is the main reason why the European Central Bank (ECB) will not cut interest rates in the first half of this year. However, if the economic growth indicators for the fourth quarter of 2023, published in March and April, are very low, this will probably reduce the inflation indicators as well.
Another argument in favor of lowering interest rates is the high level of national debt. Servicing existing loans has already become a significant burden on national budgets, and the cost of taking out new loans to stimulate the economy is high. However, current forecasts show that inflation indicators in the eurozone will not reach the target level in 2024, so the ECB has no reason to rapidly reduce the base interest rates. The president of the ECB has said this very clearly in recent speeches.
Basically we have three possible scenarios. Market expectations predict that interest rates will begin to decrease already in March or April, commercial banks believe that this will not happen before August or September, but the Organization for Economic Cooperation and Development predicts that interest rates in Europe will begin to decrease only at the beginning of 2025. Personally, I do not believe in a sharp decline in interest rates, and past events do not support this either. The ECB tends to react with delay to the necessary changes.
Changes in interest rates directly affect the exchange rate. If the forecasts are confirmed and the US Federal Reserve starts to cut interest rates as early as the first half of 2024, but the ECB does not do so until late 2024 or early 2025, then based on simple economic logic, the euro will begin to rise against the US dollar . In turn, this will have a negative impact on the economy of the largest exporters of the European Union, especially Germany. It should be noted that Germany registered a recession last year, as energy prices have stabilized at a high level, and this directly affects those companies for which energy costs make up a large part of production costs.
Unfortunately, this causes a chain reaction. Problems in the German economy have a negative impact on the economy of the Scandinavian countries, which also refers to the Baltic countries. There is reason to believe that if Germany has adjusted its economic indicators downwards, then the Nordic countries have also done so.
The difference between Sweden and Finland is mainly due to the exchange rate. The value of the Swedish krona against the euro has fallen sharply, helping to ease the economic downturn in Sweden and keeping Swedish companies competitive. However, high interest rates have had a significant impact on the real estate market, which is experiencing a downturn.
Although the weak exchange rate of the Swedish krona gives a boost to the Swedish economy, exporters and suppliers from the Baltic countries face big problems, because the high exchange rate of the euro makes the products of our companies too expensive for the Swedes. This is painfully felt by both Latvian and Estonian wooden house builders.
Finland has similar problems, and as a member of the eurozone, it also has no possibility to influence the exchange rate. Private investment in residential construction fell by 12% in 2023, and another decline is forecast in 2024.
In both Sweden and Finland, investment and private consumption have fallen, while household savings have increased. Uncertainty about the future is great. Labor market indicators remain good and unemployment is not expected to rise sharply. Wage growth is expected to outpace inflation both this year and next, meaning real household incomes will rise over the medium term. This gives hope that, at least in a couple of years, rising consumption will begin to boost domestic demand and the economy will begin to grow again.
The current forecasts show that among the Baltic states, Latvia has the best performance, Estonia the worst. Economic growth of almost 2% is predicted for both Latvia and Lithuania in 2024. Estonia’s central bank “Eesti Pank” predicted in December that Estonia’s economic well-being will decrease by 0.4%. According to “Bigbank” estimates, this forecast is even too optimistic.
Latvia and Lithuania are positive about the development of the labor market, while an increase in unemployment is predicted in Estonia. In Lithuania and Latvia, the unemployment rate will remain between 6.3% and 6.5%, while in Estonia “Eesti Pank” predicts that the average unemployment rate will reach 9% in 2024. It is possible that the current forecasts in Latvia and Lithuania are also too optimistic, because the challenges in the Baltic countries are similar. Industrial production, export, import, trade turnover and tourism have decreased, the construction industry has experienced a decline. Future results will largely depend on the success of our external trading partners.
The high price of money has also negatively affected the start-up sector. Raising money is no longer as easy as it once was, and many startups have had to downsize. As elsewhere in Europe, manufacturing has been the hardest hit, but the service sector is still doing relatively well because people have jobs and can therefore buy goods and services.
The Baltic States have to take into account one more aspect, namely the dynamics of labor costs – according to “Eurostat” data, labor costs have grown faster than productivity.
The ratio of these two indicators is shown by unit labor costs. If wage growth is faster than labor productivity, unit labor costs increase. In the Baltics, with the small exception of Estonia, changes in unit labor costs since the pre-coronavirus pandemic have been positive. Unfortunately, a situation where wages are growing faster than productivity means that company profits are falling, as wage growth “eats” profits.
Possible solutions for companies in such a situation are relatively limited. From an economic point of view, the most efficient way would be to replace people with machines (robots), but this means layoffs and requires significant financial resources. However, interest rates are currently high. Rationalization also means closing a company in one’s country and moving production to a country where labor costs are lower. Or companies will simply cut spending and production, which again means layoffs.
All these possibilities will at some point lead to an increase in the unemployment rate. The solution would be to increase productivity and move up the value-added network, but this is very difficult to do in a high-interest environment because of the additional investment required.
If our traditional partners who have made foreign investments in the past also do poorly, we end up in a vicious circle. In addition, we also need a highly skilled workforce that will not appear overnight or by itself, waiting for someone to start increasing productivity.
However, we hope that the economy will start to recover in the second half of this year. At least in Latvia and Lithuania, there are hopes for a rapid increase in state investments, using both the EU recovery fund and the “Rail Baltic” projects.
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2024-02-18 03:00:03
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