Baltic economic overview 06/2023

Although the eurozone economy has fallen into a small recession, with GDP falling by 0.1% for two consecutive quarters, Europe has managed to avoid energy crisis and since the end of summer 2022 energy prices have fallen significantly. This year in the European economy has also started better than expected and compared to the corresponding quarter of the previous year in Q1 of 2023, the GDP of the eurozone grew by 1.3%. High inflation and the efforts of central banks to combat inflation by raising interest rates, as well as recent banking problems in the US and Switzerland so far have not significantly changed the growth trends in the global economy. Weak demand for goods and falling lending have been successfully compensated for by strong growth in service sectors, and since autumn 2022 economic growth forecasts in the Eurozone as well as in the US have improved. At the same time, global economic outlook remains very uncertain. The war in Ukraine continues, energy crisis in Europe has not yet been completely overcome, interest rates have reached their highest level since 2008, bank lending standard have tightened in the Eurozone, the demand for loans is decreasing, and the risk of recession remains high.

Global commodity prices have been declining since May 2022, manufacturing has slipped into recession, as the pandemic era high demand for goods the has ended, and global logistics costs have significantly decreased. At the same time COVID-19 support measures have also mostly expired, and the economy is beginning to feel the efforts of central banks to limit inflation. For example, in the US money supply is shrinking for the first time in more than 50 years. This has eased the pressure on commodity prices, but inflation in general, both in the Baltics and in the eurozone, is still too high. Prices of services mostly continue to rise and the drop in commodity prices is not yet reflected in lower prices of goods or food.

Global inflation has started to decline, however it remains too high and decrease in inflation has so far been mainly due to cheaper energy prices. To combat inflation, the European Central Bank has raised interest rates by 4% since July 2022 to the highest level since 2008 and has signaled intention to continue raising interest rates until inflation is firmly under control. Meanwhile, the US Federal Reserve did not increase the interest rates at the June meeting for the first time since March 2023 and left FED funds rate at 5-5.25%. This is a signal that the interest rate hiking cycle in the global economy is coming to an end. However, it is possible that by the end of 2024 interest rates in the US could increase by another 0.5%.

Despite opposite signals from central banks, the financial markets are expecting a reduction in interest rates both in the US and in the eurozone as early as the end of 2023 and the first half of 2024. In the short term, inflation will certainly continue to decline and at the end of 2023, inflation in the Eurozone could be fall to very low levels, due to cheaper energy prices. However, even a sharp decline in inflation will not nescessrialy mean that inflation challenge is over. Growing geopolitical tension between the US and China is leading to a more protectionist economic policy in West, unemployment is at a record low and there is a shortage of workers in many sectors. In addition achieving climate goals in the coming decades will require very large investments in economic transformation. As a result in the near future the global macroeconomic environment could be more prone to inflation. Therefore, a short-term drop in inflation, with an otherwise unchanged macroeconomic environment, may not be a sufficient reason for a rapid reduction in interest rates, as the drop in inflation in the second half of this year does not exclude the possibility of repeated waves of inflation in the coming years.

GDP growth in the US and Europe has been better than expected since 2022, and economic forecasts for 2023 are gradually revised upwards. According to forecasts by the analysts polled by Bloomberg, in 2023 the US economy could grow by 1.2% and growth in eurozone could reach 0.6%. However, the forecasts for 2024 have become a little more cautious and the eurozone economy is expected to grow by only 1%, while the US economy could grow by 0.7%. However, economic growth indicators currently do not describe overall situation in the economy, as there are large differences between different sectors. Manufacturing has slipped into recession after several years of rapid growth, affecting both trade and logistics, while rising interest rates have cooled housing markets and significantly reduced demand for credit in the eurozone. Commercial bank deposits are shrinking in both the US and the eurozone due to rising interest rates and money supply has begun to shrink. The rapid outflow of deposits was one of the factors that caused the insolvency of some US banks at the start of this year. So far, however, these have been isolated cases and they have not had a wider impact on the economy. The share of overdue loans in the US and Europe is low, and there is currently no reason to worry about a rapid increase in insolvencies. The current situation in the financial sector is significantly better than it was in 2007-2008. year. Meanwhile, service industries are currently growing rapidly. For example, the number of commercial flights worldwide has exceeded the level of 2019, and it is the very good performance of the service industries that has allowed us to avoid a deeper economic downturn.

Compared to the previous year, in Q1 of 2023, GDP in Latvia increased by 0.8%, while in Lithuania and Estonia GDP decreased by 3.2% and 2.5% respectively. Although inflation in the Baltic countries has started to decrease, it is remains very high and trade volumes have decreased due to the decline in the purchasing power. Rising interest rates have reduced housing market and lending activity also in the Baltics, while after several years of strong growth, external demand for exports has become noticeably weaker and industry has slipped into recession. At the same time service sectors continue to recover rapidly and a significant increase in EU investment is also expected in the Baltic region this year. In Latvia, the positive GDP growth is mostly due to a stronger base effect and higher growth in the service sectors, which were still affected by the restrictions of Covid-19 in the 1st quarter of 2022.

Economic growth in the Baltics has currently stalled, however, the situation in different sectors of the economy is very different. Pandemic era strong global demand for all kinds of goods has ended, manufacturing and supply chains have returned to normal functioning, and inventories of many goods have returned to normal levels. At the same time, the high inflation, the decline in the purchasing power and the subsequent rise in interest rates have sharply cooled the housing markets in Germany, Sweden and United Kingdom, which are large markets for the Baltic manufacturers of building materials and wood products. As a result export demand has decreased and manufacturing output in the Baltics in the first four months of 2023 has decreased by approximately 10% in Lithuania and Estonia in comparison to the previous year, as well as by almost 6% in Latvia. In Q2 2023 new industrial orders in the Baltics have slightly increased, however, the decline in the manufacturing caused by the inventory cycle will most likely continue until the end of 2023 and positive growth could resume only at the beginning of 2024. Meanwhile, rapid growth continues in the service sectors and in the 1st quarter of 2023, the service exports of the Baltic countries increased by approximately 15% compared to the previous year. The export of IT and business services has long been one of the fastest growing industries in the Baltic States, while the tourism, entertainment and restaurant industries continue to successfully recover from the Covid-19 pandemic, although the number of foreign tourists in the Baltic States is still lower than in 2019.

Rapid rise in interest rates since the spring of 2022 is increasingly affecting the housing market and construction in the Baltic States. Since the middle of 2022, the volume of newly issued mortgage loans in the Baltics has decreased by 15-30%. The increase in interest rates has worsened housing affordability and reduced the number of real estate transactions, however, loan payment discipline in the Baltics remains good and the share of overdue loans is low. As a result housing prices in the Baltic countries increased by an average of 20% in 2022, although in recent months there are increasing signs that housing prices in the Baltics have stabilized and, at least at the moment, are no longer growing. Weaker lending has affected construction, and in Estonia, construction volumes fell by more than 10% in Q1 of 2023 compared to the beginning of 2022. Meanwhile, in Lithuania, construction volumes remained at the previous year's level, but in Latvia, after a weak 2022, construction increased by almost 17%. The growth of construction in Latvia is basically related to the rapid growth of state investments, and in the next two years, a large amount of EU fund investments will flow into the Baltics, which will partially compensate for lower construction activity in the private sector.

Period of sharpest increases in consumer prices has ended and since the beginning of the year, inflation in the Baltic countries has decreased from almost 20% to slightly more than 10% in May. The differences in the dynamics of inflation between the Baltic States can largely be explained by the different energy cost support measures. Now the big question is when and if food prices will start to decrease, which continued to rise in 2023 despite falling unprocessed food and energy prices in the global markets. In the last two years, food prices in the Baltics have grown much faster than elsewhere in Europe or the world. This is partly due to the increase in the prices of energy resources and other commodities, which the Baltic region has probably felt more because of our proximity to the war in Ukraine. However, not all of the differences in food price inflation between the Baltics and other European countries can be explained by macroeconomic factors, and as energy prices normalize, a wider reduction in food prices is also possible. There are some good news - in May, for the first time since August 2021, food prices in Latvia and Estonia decreased by 0.1%, while in Lithuania they remained unchanged. A further reduction in food prices is certainly possible in the Baltic countries until the end of summer. Meanwhile, prices not related to food and energy in the Baltics continue to grow by more than 10% per year, which shows that inflation is no longer related only to external cost factors and there is a risk that it could become persistent. Average wage in the Baltic countries in the Q1 of 2023 has grown by 12-13% compared to the previous year. And, despite the slowdown in economic growth rates, unemployment in the Baltics remains very low, although it has increased slightly in Lithuania and Estonia in recent months. The number of people of working age in the Baltics is decreasing and the lack of labor is a significant obstacle to economic growth. Therefore, companies are not in a hurry to reduce the number of employees and tight labor markets will continue to put pressure on the prices of services.

This winter, the Baltic region has managed to avoid the worst case energy crisis scenarios and energy prices have decreased significantly. However, the situation in the economy is still very uncertain and there are no significant improvements in short-term economic indicators. On the contrary, in April and May, the economic sentiment in the Baltics has worsened again, demand in manufacturing remains weak and the decline in production volumes will continue most likely until the end of the year. In addition, high inflation has reduced purchasing power of households and, despite the rapid rise in wages, retail sales volumes are slightly shrinking. Also, the turnover of payment cards does not indicate any increase in spending since the end of the heating season. In the coming months, however, the situation for consumers will begin to improve. Energy prices are decreasing and a slight monthly deflation is possible in the Baltics in the coming months, while the average annual inflation in the Baltics in 2023 could be around 9-9.5%. In the second half of the year, the purchasing power of the households will begin to grow again, however, GDP in 2023 as a whole is likely to decrease slightly. However, in 2024, the Baltic region is likely to return to positive growth again. This will be facilitated both by the recovery of industry after the end of the destocking cycle, and also by the large investments of EU funds, which will flow into the economies of the Baltic countries in the next year.

The war in Ukraine continues, inflation remains high and rapidly rising interest rates have cooled the housing market. Given the high levels of government debt, interest rate hikes are likely coming to an end, but financial market forecasts for interest rate cuts as early as next year may be premature. Inflation is still too high and without significant changes in the economy, central banks may be slow to cut interest rates. Therefore, you may have to live with EURIBOR rates of 3.5-4% for a longer time. At the same time, financial markets are still signaling a high risk of recession in the coming year. Recent problems in the US banking sector are a signal that rapid interest rate hikes can pose risks to financial stability. In addition, the economic recovery in China is slower than expected, in Europe the high debt levels of some countries are a cause for concern and, despite the large drop in energy prices, business sentiment has slightly deteriorated again in the Eurozone since April. However, these recession signals should be taken with caution, as the world economy has still not fully recovered from the impact of the pandemic and sentiment indicators are currently very volatile.