Economic recovery in the Baltic States is expected to be rapid

Global industrial sentiment has reached record highs in recent months, as demand has recovered much faster than expected and in some sectors, such as semiconductor manufacturing, supply is lagging behind demand. At the same time, with declining COVID-19 infection rates in developed countries, sentiment in the service sector has also begun to improve. In addition, the second wave of COVID-19 in the developed world has caused significantly smaller decline in economic activity than the first wave. Optimism about the economic growth prospects is also visible in the financial markets, and global economic growth forecasts are being revised upwards. According to the April forecasts of the International Monetary Fund, the world economy will grow by 6% in 2021, and by 4.4% in 2022. Such a rapid recovery in the global economy has been made possible to a large extent by the support of unprecedented fiscal and monetary policies. With the support of central banks, the US budget deficit in 2021 could exceed 15% of GDP for the second year in a row, while in the euro area the budget deficit will exceed 7% in 2021 and budget deficits have increased significantly in the Baltic States as well.

In the Baltic States, too, 2021 has begun with the second wave of COVID-19 and repeated restrictions in the economy. The good news is that the experience of Israel, the United Kingdom and also the United States shows that COVID-19 vaccines are effective and that this is the way to overcome this crisis. At present, the pace of vaccination in the European Union is a few months behind those countries, but the availability of vaccines is improving, which means that the COVID-19 pandemic is coming to an end, at least in developed countries. At the same time, there are increasing indications that, like other coronaviruses, COVID-19 may be a seasonal virus and therefore the incidence will decrease in the coming summer. However, unpleasant surprises are possible in the fall, especially if vaccinations are not enough to achieve crowd immunity.

Short-term economic indicators suggest that the start of 2021 in the Baltic economies has not been better than expected and the economic downturn in the second wave will be significantly smaller than in the first wave of COVID-19 in spring of 2020. Businesses and the economy continue to adapt to the constraints of COVID-19 and find ways to, for example, develop remote selling, while economic activity in manufacturing and construction has not declined. This has allowed us to improve our economic growth forecasts in recent months, and according to our forecasts, the Latvian economy could grow by 3.6% this year. In Lithuania and Estonia, too, growth will exceed 3% this year, but the Baltic countries are unlikely to be among the growth leaders this year, as last year the economic performance was better than elsewhere in Europe and therefore the recovery potential in 2021 is lower. The fight against COVID-19 is also not going as well today as it did last year, and there are still many constraints on the economy. At the same time, in my opinion, it is reasonable to expect that economic activity will increase significantly in the second half of this year and next year, and in 2022 growth in the Baltic region could reach 6%.

Unlike during the first wave of COVID-19, the second wave has mainly affected those sectors whose activities have been restricted by the state and manufacturing has not been significantly disrupted. The global manufacturing cycle is currently in a strong upswing, with an unexpectedly rapid recovery in demand from the initial COVID-19 shock, a shift in the structure of demand from goods to services, and low inventory levels in many sectors due to last year's supply chain disruption. According to surveys of Baltic entrepreneurs, export orders in industry are also growing in our region, and in the first two months of 2021, production volumes in Latvia have grown by 2.5% compared to the beginning of 2020. In Lithuania, meanwhile, manufacturing growth in the first two months of the year reached 6%, while in Estonia production grew by 5%. Electricity consumption in the Baltics will continue to grow and industrial growth will accelerate significantly in the spring months as production volumes are compared to the first wave of COVID-19. In addition, export growth is currently driven not only by rising production but also by rising prices. In recent months, the prices of many natural resources have risen sharply on world markets, including grain prices, which have risen by more than 40% since the middle of last year and reached their highest level since 2013. In turn, timber prices on the US stock exchanges have almost tripled since the middle of last year, and this effect is partly felt in the Baltics as well. Both grain and wood products make up a significant part of our exports, although not all wood product producers can pass on the increase in raw material prices to the consumer.

However, as COVID-19 pandemic recedes, these sectors have high potential for recovery. For example, in the tourism sector in Latvia, since the end of 2019, around 75% of workers have lost their jobs or are receiving downtime benefits. Significant declines in 2020 were also recorded in entertainment, catering and passenger transport, as well as in other service sectors. As a result, exports of services in 2020 in Latvia and Estonia decreased by more than 20%, while in Lithuania export of services fell by 9%. However, the good news is that the experience of both the Baltic States in the summer of 2020 and other countries that have managed to limit the spread of COVID-19 shows that the services sector is recovering rapidly as soon as the epidemiological situation allows. The recovery of the services sector will be an important factor in overall economic growth in the second half of 2021 and in 2022, if the COVID-19 pandemic is contained.

The impact of the COVID-19 pandemic on the economy and consumption has been very uneven, and in 2020, with restriction affecting many services sectors, demand for goods increased and retail trade was one of the best performing sectors of the economy. Currently, the activity of the industry is restricted, but the income and savings of the population are growing, while entrepreneurs continue to adapt to the new situation by expanding trade on the internet. In the first two months of this year, Latvia's retail trade turnover decreased by about 5%. This is a significantly worse result than in Lithuania, where sales increased by 21% year-on-year in March, and in Estonia, where sales grew by 5% in the first two months of the year. This, of course, raises questions about the effectiveness of Latvia's COVID-19 pandemic control measures. At the same time, the overall decline in retail sales masks significant changes in the structure of the sector, as food and distance sales have increased, while in other categories sales have decline. The good news is that our customers' credit card turnover data show that consumer spending on goods has been gradually improving since mid-January in both Lithuania and Latvia, and turnover in goods segments is increasing whenever restrictions are eased. This suggests that demand is strong and that the industry will be able to recover as soon as it is possible to lift remaining restrictions.

There is currently a paradoxical situation in the labor market in the Baltics. Unemployment has risen sharply, however it is difficult to answer the question how high the actual unemployment is, because economic activity is artificially limited and many workers receive downtime benefits. According to official statistics, in the 4th quarter of 2020 it reached 7.9% in Latvia, 7.4% in Estonia and 9.1% in Lithuania, while in March this year the registered unemployment in Latvia reached 8.2%. In addition, in February 2021, more than 60,000 people in Latvia received downtime benefits. In my view, the true level of unemployment and the long-term impact of the pandemic on the labor market will only be assessed once the various restrictions have been lifted. However, despite the rise in unemployment, as a result of large-scale state support, the income of the population has increased and households, as well as companies, are rapidly accumulating savings in banks. In February, household savings in the Baltics were 15-22% higher than before the start of the pandemic. At the same time, we have borrowed cautiously in a pandemic and the loan portfolio has not grown significantly. These additional savings represent a significant potential for deferred consumption of resources in both the services and trade sectors.

State aid instruments have played a key role in mitigating the economic losses from COVID-19 crisis. Lost income by employees and companies in the most affected sectors is being at least partially compensated by governments, while investments in construction have been significantly increased, and various one-off benefits approved to help to stimulate economic activity. All this is, of course, at the expense of the budget deficit and the increase in public debt, and in 2021 the government budget deficit in Latvia could exceed 9% of GDP instead of the previously planned 3.7%. In Lithuania and Estonia, the budget deficit could reach 5% and 7% of GDP, respectively, according to the forecasts of the International Monetary Fund. This is a very large support for the economy, but the Baltic States are not unique in this respect and macroeconomic policies in general are currently very stimulating almost everywhere in the world, although it may be a great challenge to stop this support in the future. Meanwhile, the replacement of lost income in the Baltics has reduced the decline in economic activity and stimulated the real estate market, where interest in larger housing close to the capital, as well as in the regions, has grown particularly rapidly. It also stimulates construction, and in the coming years, substantial funds from the EU Economic Recovery Fund and the implementation of the Rail Baltica project will flow into the economy, as well as construction.

In my opinion, the recovery of the service sectors, the upswing in the industrial cycle in the world economy, and the inflow of substantial EU funds into construction are very strong arguments why the economic growth of Latvia and the Baltic States in the second half of 2021, as well as in the next two years, will be very rapid. At the same time, however, there are significant risks and the new waves of the COVID-19 pandemic in the Baltics remain one of the most significant. It is clear that the economic situation and its further development in the coming months will largely depend on how quickly we succeed in achieving herd immunity through vaccination. The current prevalence of the COVID-19 virus in the Baltics suggests that the virus may be seasonal and therefore, in my opinion, the biggest risks are related to the second half of the year. At the end of April, only slightly more than 10% of the population in Latvia was vaccinated against COVID-19, which is half as much as in Lithuania and Estonia, and without significant improvements in the vaccination process, we might fail to achieve herd immunity by autumn and this could mean new restrictions could be necessary.

Against the background of the severely affected service sectors, it is easy not to notice that in 2020 almost all service sectors grew more slowly than before. For example, exports of the IT and business services sector in Latvia and the Baltics have grown by an average of about 20% per year since 2016. However, in 2020, the growth of IT and business services exports in Latvia was only 3.6%. A similar slowdown in growth rates was observed last year in Lithuania and Estonia. This may be due to general caution or the fact that professional services industries may work remotely, but the COVID-19 shocks have made it difficult to attract new customers and business development remotely is not so easy. This is important because the professional services sector has been a significant source of new jobs over the last 10 years. Therefore, I hope that these trends will change as soon as the COVID-19 pandemic is over, as global demand for digital services has certainly not declined. In addition, there is a great deal of uncertainty in the area of services about when the tourism industry could recover. The summer tourism season is fast approaching, but according to Google, the interest in Airbaltic and hotels in the Baltic capitals is not great. COVID-19 infections rates in the Baltic States is much higher this year and this could mean that the recovery in the tourism sector may not happen in 2021.

To overcome the COVID-19 pandemic, the Baltic States, like other developed economies, have implemented extensive economic support measures. As a result, the budget deficits have risen sharply and certainly are not sustainable in the long run. This means that in the coming years it will be necessary to strike a balance between improving public finances and, at the same time, not stopping economic support measures too quickly before sustainable economic growth returns. This is, in my view, is a very difficult task and there are many opportunities to make mistakes, because there are still many unknowns in the economy and we will only know how strong the expected economic growth cycle will be when economic support measures are removed. The Baltic States have virtually no experience in managing economic cycle with fiscal policy, and the forthcoming elections in Latvia will put a lot of pressure on additional expenditures.

Economists' optimistic forecasts at the moment are mainly based on the expected recovery in the service sectors and strong growth in construction, which will be ensured by the investments of the EU Economic Recovery Fund and the construction of Rail Baltica. At the same time, it is important to remember that the construction industry was not significantly affected by the COVID-19 pandemic, and its share of the Baltic economy in 2020 was even slightly above the average of the last 20 years. This means that this new construction cycle is currently starting at a relatively high level and suggests that there is probably not much spare capacity in the construction sector. As a result of the COVID-19 pandemic, it may also be difficult to attract external labor, and it must be taken into account that an upward construction cycle is currently expected in other European countries as well. Overall, these factors certainly pose some risk of overheating in construction, with the result that expected growth may be more in prices and less in real construction volumes.

Extensive global fiscal and monetary support measures have led economists and financial market participants to worry about rising global inflation. And now there are many signals that global inflation will indeed rise in the coming months. Disruptions in production chains have led to shortages of goods in a number of sectors, prices are rising for wood, food, industrial metals and other natural resources, while freight costs for goods shipments have increased significantly. The base effect will also be significant in the coming months, as consumer prices will be compared to the lowest point of the COVID-19 crisis. At the same time, inflation is not in itself a clear downside risk, as some price increases after a long period of low inflation is even desirable. It stimulates investment, reduces the debt burden and improves the effectiveness of monetary policy. At present, low inflation is one of the factors that allows for such extensive stimulus policies in the world. However, return to persistant inflation would be an unpleasant surprise and would lead to more active thinking about both the normalization of fiscal policy and more restrictive monetary policy, which could also mean lower global growth rates. What does this mean for the Baltics? In my opinion, the coming years for Latvia and the Baltics, when our economies will recover from the COVID-19 pandemic, will be a period of rapid growth, but the return to inflation and other risks are a reminder that positive economic forecasts are still forecast and may not materialize.