Overview of the Baltic Economy

In recent months in both the US and the euro area economic situation been better than expected. For example, unemployment in the US has declined to 3.4% in January, the lowest it has been in over 50 years, indicating a healthy labor market. Similarly, GDP in euro area in Q4 2022 increased by 1.9% compared Q4 2021. Inflation also appears to have peaked and is now beginning to decline. These are positive trends, however uncertainty remains high, and significant risks remain. While COVID-19 pandemic is now in the rear-view mirror, new risks have emerged, including Russia's invasion of Ukraine, an energy crisis in Europe, the highest inflation in 30 years, and rapidly rising interest rates, and economic slowdown in China. These factors have disproportionately affected the Baltic region, causing economic growth to come to a near halt in the second half of the year. However current situation in the global economy also remains very difficult to read, as there is a strong divergence between various economic data. While some indicators, such as positive GDP growth, low unemployment, growing retail sales suggest a robust and healthy economy, other factors, consumer and business sentiment, and leading indicators in financial markets continue to point to a high risk of recession.

Russia's invasion of Ukraine, coupled with unfavorable weather conditions for renewable energy production and issues in the French nuclear sector, led to record-high energy prices during the summer of 2022. This crisis became one of the main risks to the EU economy. However, a combination of energy savings, increased natural gas imports from other suppliers, and the use of other energy resources such as coal and wood, prevented the crisis from escalating further. As a result, natural gas prices have dropped over 75% from their 2022 highs, and natural gas storage levels in the EU remain near record highs for February. Since 2021, EU natural gas imports from Russia have decreased by almost 80%, but other sources such as Norway, the United States, Qatar, and Africa have largely substituted for this lost supply. While the overall natural gas supply in Europe has decreased by only 10-15%, consumption has declined by more than 10% in the EU and by over 30% in the Baltic region as countries have switched to other energy sources. As a result, natural gas storage in Latvia remains above 40% full. These trends, along with the decline of energy-intensive manufacturing, have reduced the risk of a significant energy crisis also in the next winter.

Global economy has weathered the storm and so far avoided a recession. Energy outlook in Europe is improving as a mix of energy savings, increased natural gas imports from other suppliers, and the use of other energy resources has averted a major crisis. In addition, the unexpected economic resilience to high inflation and rising interest rates in the US and euro area is an indication that businesses and consumers are adapting to the changing landscape, while lifting of COVID-19-related restrictions in China will boost economic activity in the world’s second largest economy. Despite the lingering risks and uncertainties, such as the impact of rising interest rates on the real estate market and lending, the economic outlook for 2023 appears brighter than it did in the autumn of 2022. This is reflected in better economic forecasts, including the Bloomberg consensus GDP forecasts for the euro area in 2023, which have improved from -0.1% in November 2022 to 0.3% now. And in January 2023 International Monetary Fund increased forecasted global GDP growth in 2023 by 0.2% to 2.9%.

Inflation has been one of the most pressing challenges facing the global economy over the last two years, but there are now signs that it has peaked and will begin to decline in 2023. In the US inflation has already decreased from 9.1% in June 2022 to 6.4% in January 2023, while the euro area inflation fell to 8.5% in the same month. Although inflation in the Baltics remains high, it has already dropped below 20% in Lithuania and Estonia, and by mid-2023, it could decline below 10%. There are signals that inflation will fall further, as energy prices in Europe are returning to more normal levels and global oil prices have dropped from over $120 per barrel to around $80 now. Additionally, container shipping costs have fallen back to pre-COVID-19 levels, indicating a significant improvement in global manufacturing supply chains. COVID-19 support measures have also ended, interest rates have increased significantly, and money supply in the US is shrinking for the first time in over 50 years after growing by more than 25% in 2021. As a result, financial markets increasingly anticipate that central banks are nearing the end of the interest rate hike cycle. However, it is important to note that inflation has not yet been defeated, and it could still pose new threats to the economy. Service price inflation remains high, unemployment is low, and there is significant pressure to raise wages. This means that central bank interest rates will remain restrictive, unless there are any new shocks in the economy, and we should not expect significant interest rate cuts in the near future.

Proximity to war in Ukraine and trade exposure to Russia have contributed to economic slowdown in the Baltics while high energy prices and rising global commodity prices have contributed to inflation that exceeded 20% at the end of 2022. As a result, GDP growth in the Baltic has fallen faster than in other parts of the EU and GDP growth slowed to near 0% in second half of 2022. In Latvia in Q4 GDP remained unchanged while in Lithuania GDP in decreased by 0.4% compared to Q4 2021. In Estonia in Q3 2022 GDP fell by 2.3% compared to the same period a year ago, although this is partially due to strong base effects coming from a one-off investments in 2021.

In 2022 the Baltic region narrowly avoided entering a recession, however manufacturing sector has already entered one. The waning of the post-pandemic surge in demand and the rebuilding of inventories have led to a slowdown in the inventory cycle, and new industrial orders in the Baltics have decreased noticeably. In December 2022, manufacturing output in Latvia declined by 2.6% compared to the same period a year ago, while output fell by 11.5% in Estonia and 10.3% in Lithuania. While high energy costs have been a factor in declining output, the slowdown is affecting most industrial sectors and is affecting other countries as well. Leading indicators, such as global export orders, suggest that demand in manufacturing will remain weak in the first half of 2023, but recovery could start in the second half.

Despite high inflation, consumers in the Baltic region continue to spend, as nominal spending and retail sales in euro terms grew by more than 20% in 2022. However, the waning of consumer confidence and the fact that consumer prices increased faster than wages has caused a decrease in purchasing power. This has led to stagnant real consumption and a decrease in retail sales at constant prices in Baltics in December 2022 by more than 3% compared to the same period a year ago. The impact of high energy prices has become more noticeable, although government support measures have helped ease the burden. To offset inflation, some households are using COVID-19 savings and increasing their use of consumer credit. Consumers are also changing their consumption habits and basket, seeking cheaper alternatives. For instance, food price inflation in Latvia reached 29% in December, but retail turnover in euro terms in food stores grew by only 16%. There is good news, though, as gas and electricity prices are falling, and if these trends persist, heating tariffs will decrease in the second half of the year. The labor market situation remains favorable, with growing wages expected to support consumption in 2023. However, retail volumes in the Baltics in 2023 are unlikely to increase significantly and could decrease slightly due to still high inflation.

Over the past two years main challenge for the construction sector was increasing costs, but the real estate market is now facing a new challenge as higher interest rates has reduced new mortgage lending and activity in the real estate market is slowing down. While these trends are not yet as pronounced as in other global housing markets, it is clear that rising interest rates will be a headwind for the construction sector. Global housing markets have already begun to cool rapidly and in the US existing home sales and home builders confidence has declined noticeably while in Sweden house prices have already decline by more than 15% from their peak. The housing markets in the Baltics have been more balanced, with price growth remaining in line with wage developments over the last decade. However, certain areas of the real estate market have seen significant growth since the onset of the COVID-19 pandemic and is some segments corrections are possible. High share of floating rate mortgages in the Baltic region means that homeowners with mortgages will feel the impact of rising Euribor more than in other countries, although debt levels in the Baltics are among the lowest in the euro area and impact on households will be less severe than from high energy costs. Furthermore, the Baltic region is set to benefit from large investments from European Union funds over the next two years, with the Latvian government planning to increase its investment by 700-900 million in 2023. This will help to boost the construction sector and overall economic growth in the region at a time when investment activity in the private sector is lower.

In December 2022, unemployment rates in Latvia, Lithuania, and Estonia fell to 7.1%, 5.8%, and 5.7%, respectively. In the same period, wages continued to grow, with the average wage in Estonia increasing by 8.1% in Q3 2022, compared to the same period a year ago. Meanwhile, Latvia saw wages grow by 6.3%, and Lithuania by 12.6%. While economic growth has slowed down, companies are showing caution but have not resorted to laying off employees. Due to adverse demographics, the number of people of working age in the Baltics is decreasing, with more people retiring every year than entering the labor market. And situation is not expected to change even with migration from Ukraine. This demographic problem is especially felt in sectors where the average age of workers is higher, such as health care and education, and part of the industry, transport, and state administration structures. Sectors where many young people work, such as catering and accommodation, are also affected. During the pandemic, companies faced difficulties in finding new employees to replace those who were dismissed. As a result, there are currently fewer vacancies and job advertisements in the labor market. However, companies are not in a hurry to lay off their employees.

However, growth prospects for 2023 are better than they were in the fall of 2022 and while the economic situation is challenging, there are reasons to be cautiously optimistic. The worst-case energy crisis scenarios have been avoided, although the energy situation is not yet fully resolved and prices remain high. Inflation has peaked and is expected to decline sharply by the middle of 2023. For now, we haven't seen a drop in natural gas prices in Baltic inflation numbers, but if prices remain at this level, heating tariffs should decrease significantly in the Baltic states next autumn, and there is a possibility of deflation in late 2023 or early 2024. At the same time consumption remains relatively stable despite weak consumer confidence. The real estate market is starting to cool down, but less so than in other countries and significant EU fund investments will flow into our region in the coming years. Business sentiment in the Baltic states is improving, with economic sentiment suggesting 0% growth but not a major recession. However, a recession is still on the table, possibly in the second half of 2023. Low unemployment is a good sign, but it is a lagging indicator and says relatively little about the future growth prospects. Higher interest rates are already cooling the housing markets globally and many signals in the world economy still point to the approach of a recession. The manufacturing industry in the Baltics is already in a recession, and the inventory cycle will likely last until the end of the year. Better news could be expected this year from China, where the economy is expected to recover from the lifting of COVID-19 restrictions. Higher demand in China may once again drive-up natural resource prices, so inflationary challenges are certainly not over, although financial markets expect that interest rate hikes by central banks are likely coming to an end. According to my forecasts, inflation in the Baltic states could be in the range of 7-9% this year, while GDP in the Baltic states could shrink by 1-1.5% in 2023, with growth of 3-4% expected in 2024.