The Baltic States are successfully recovering from the COVID-19 shock, but uncertainty remains
The economic downturn in the Baltic States this year will be significantly smaller than forecast at the beginning of the crisis
The rapid spread of the COVID-19 virus in recent months has severely limited the activities in many industries and caused a very severe global as well as Baltic economic downturn. Initially, high uncertainty led to a sharp reductions in economic growth forecasts, but it is now clear that the worst-case scenarios so far have not materialized, and the decline in economic activity in the Baltics in 2020 will be significantly smaller than in many other countries. In the second quarter of this year, euro area GDP contracted by 15% year on year. Meanwhile, Latvia's GDP contracted by 8.9% in the second quarter, while Lithuania's and Estonia's GDP contracted by 4.2% and 6.9%, respectively.
Short-term economic indicators suggest that the crisis peaked in mid-April, and that the economic recovery has been unexpectedly strong since then. Effective containment of the COVID-19 virus, balanced economic development before the crisis and sufficiently effective economic support measures have helped to mitigate the negative effects of the shock. In addition, the tourism and leisure sectors hard hit by the crisis are less important in the Baltic economies than elsewhere in Europe. These factors are also reflected in improving economic forecasts.
As in the Baltic States, the global economy as a whole has seen significant improvements since April. Business sentiment in the world's largest economies has returned to positive territory, export orders in industry have recovered from the lows in the spring and indicate a stabilization in world trade. Unprecedented monetary and fiscal stimulus measures have been crucial in stabilizing the global economy, but COVID-19 continues to spread globally, unemployment remains well above previous levels and business sentiment deteriorated again in several countries in August. Various other short-term indicators, such as payment card turnover, population mobility, air travel and restaurant bookings, also suggest that the economic recovery in much of the world is still incomplete and the initial rebound after the lifting of restrictions on social distancing measures is over. There is still optimism in the financial markets, but markets remain volatile. Hopefully, this volatility is not a signal of a new downturn, but the global economy could spring some unpleasant surprises in the coming months.
Although the decline in GDP in Latvia and Estonia in the second quarter was significantly greater than in Lithuania, these are rather short-term divergences, and, in my opinion, will not lead to new gaps between the Baltic States. For example, indicators such as Google and Apple's population mobility, payment card turnover, retail and industry output have been very similar between the Baltic States since the beginning of the crisis. Latvia has been affected more than the other Baltic States by problems in the aviation and transit sectors, and the Baltic States have had a different approach to economic support measures. But these are temporary factors, and so far the rise in unemployment in the Baltics has been identical, and differences in economic performance should narrow in the coming quarters.
The second quarter was certainly the lowest point of this crisis, and economic activity in the summer months in the Baltics was significantly higher than in April or May. This means that the Baltic GDP indicators will improve significantly in the third quarter, and in the year as a whole decline in GDP will not exceed 5% in any of the country. However, there are now growing signs that the initial rapid recovery phase of the economy is over and improvements are slowing. Unemployment in Latvia and Lithuania exceeds 8%, wage growth has slowed, and various economic sentiment indicators in Europe in August indicate only a moderate economic recovery in our main export markets. The number of vacancies has not returned to the previous level either, and since July it has not increased in Latvia. At the same time, the number of COVID-19 cases in the Baltic States has started to rise again, posing new risks. All this suggests that economic growth next year could be slower than expected, and the Baltics will return the previous level of GDP only in 2022.
Resilient domestic consumption is one of the reasons why the economic downturn in the Baltics this year will be significantly smaller than forecast at the beginning of the crisis. In May and June retail trade in the Baltics returned to positive growth compared to the previous year, and business confidence in retail trade is now significantly higher than in other sectors. Online shops, as well as sellers of building materials, furniture, sports, leisure and electrical goods, have performed best during this time. We have also seen these trends in retail in recent months in our bank's customer payment card transactions. However, it is important to remember that retail sales is not all consumption and that the situation in retail trade is certainly significantly better today than in the economy as a whole. It is clear that the risks associated with the spread of COVID-19 are lower in retail trade than in the entertainment and other service sectors, whose functioning is still restricted.
GDP data show that in the second quarter, the in the Baltics largest declines were recorded in the hotel and restaurant, arts and entertainment, and transport services sectors. The output of these sectors has decreased by more than 20% compared to the previous year and in some cases even by more than 50%. We see similar trends also in our customers' payment card turnover data. For example, spending on leisure and hotel services is still at least 30% lower than before COVID-19, while spending on aviation has fallen by more than 70%. Part of this unspent expenditure has probably been redirected to the consumption of goods, which at least partly explains the unexpectedly positive performance retail trade. In the summer months, the economic activity in the service sectors has significantly improved, which was also facilitated by the creation of the Baltic Travel Bubble. However, it is clear that a return to previous levels in these sectors will only be possible once a vaccine or effective treatment against COVID-19 is available.
In the short run, the recovery of the Baltic economies has been driven by domestic consumption, but there have also been significant improvements in industry and exports compared to the spring months. In July, manufacturing output and merchandise exports in the Baltics were already close to or even above the previous year's level. This is a significantly better performance than many other European countries, and the manufacturing as a whole will shrink only slightly this year. This positive performance is both due to the effective control of the spread of COVID-19 virus, which allowed to take advantage of production interruptions elsewhere and gain new orders, and to changes in the consumption structure after COVID-19, which has been favourable for Baltic producers. At the same time, rapid continued growth in industry in the coming months is unlikely. In Europe, business sentiment deteriorated slightly in August and further growth will depend on both the success of COVID-19 and the effectiveness of economic support programs.
Remote working and social distancing measures have significantly changed consumer behaviour in recent months, and this is also affecting economic performance. It is not just about consumers moving from services to trade. Spending more time at home has led to the desire to improve the home and, for example, to create a workplace. As a result, the demand for building materials and furniture, while decreased availability of entertainment and leisure opportunities – has boosted demand for sports equipment. There has also been growing interest in buying private homes in many parts of the world, which has boosted construction, with lumber prices on US exchanges reaching record highs. Interest in private houses has also grown in the Baltic States, while activity in the apartment segment is still lagging behind the previous level. It is currently difficult to judge the extent to which these changes are permanent or temporary, but they are already having a significant impact on economic performance.
Along with the decline in economic activity, the unemployment rate in the Baltics has also risen significantly in the second quarter, but the rise so fa has r been smaller than expected. In Latvia and Lithuania, the unemployment rate in the second quarter reached 8.6% from about 6% at the end of 2019, while in Estonia the unemployment rate increased from 4.1% at the end of the previous year to 7.1%. This is a significant increase, but economic activity has rebounded significantly since April, and a substantial further rise in unemployment seems unlikely. Since mid-July, the registered unemployment rate in Latvia has decreased from 8.6% to 8.1%, even despite the termination of the benefits for furloughed workers. The COVID-19 crisis has also hit the tourism, leisure and other service sectors hardest in the labour market. The activity of these sectors is still partially restricted. Meanwhile, in other sectors, entrepreneurs' employment expectations are improving, but they are still negative. Therefore, it will take time to return to previous levels of unemployment. This, together with significantly slower wage growth, has reduced household incomes, and these changes will be reflected in consumption dynamics in the coming months.
With the fall in economic activity and rising unemployment in the Baltics, inflation has fallen sharply, and in recent months has even slipped into deflation. Rising unemployment has significantly dampened the rise in service prices but falling oil prices have also played a major role in low inflation numbers. This has reduced fuel prices, and we are now also seeing the impact of oil prices on lower heat tariffs. At the same time, large budget deficits and monetary stimulus measures around the world have raised the question that inflation could rise more rapidly in the coming years. It is possible, however similar concerns were raised after the 2009 financial crisis and these have so far been unfounded. Rising global unemployment will dampen wage growth, the COVID-19 virus remains a significant risk to economic development, the private sector is cautious about new investment, and consumer inflation expectations have not changed significantly. All this limits the potential rise in consumer prices, and deflation remains a higher risk than inflation in the short run.
COVID-19's initial economic shock has been overcome and many economic indicators are improving. However, the recession is probably not over yet, neither in Latvia nor in the world, and uncertainty remains very high. The biggest risk to growth at the moment is certainly posed by the possible second wave of COVID-19 infections, but there are other risks as well. The political situation in the world as a whole, as well as in many countries internally, is unstable, while optimism in the financial markets could still prove to be unfounded. The full economic recovery is also threatened by various recessionary processes, such as rising long-term unemployment and corporate insolvencies, delayed investments during the crisis, and declining consumer confidence. For example, in the Baltics, the COVID-19 shock did not directly affect the construction industry, but builders' sentiment has deteriorated significantly and points to a decline in construction in the second half of the year as the private sector has significantly reduced its investment plans. This will affect both the economy and employment, and will slow down growth, even if the risks of COVID-19 diminish.
Better-than-expected economic outlook raises questions about how much additional stimulus support is needed. So far, none of the Baltic States has made significant mistakes in crisis management. However, in my opinion, there is a risk in the coming years both of overstimulating the economy by unnecessarily increasing public debt and heating up the construction sector, and of under-supporting growth by reducing the deficit too quickly. In addition to the state budget expenditures, significant funds from the EU Reconstruction Fund will flow into the Baltic economy in the coming years, and it is very important to invest these funds prudently to ensure long-term growth.