The Baltic economy has recovered to pre-COVID-19 levels

After a sharp global economic downturn last year, a rapid economic recovery is expected in most countries around the world this year, and GDP in the Baltic States has already reached pre-crisis levels in the first half of this year. Business sentiment in the eurozone, the US, China and other major economies is very high, and new orders in global industry continue to grow. At the same time, with the gradual lifting of COVID-19 restrictions in developed countries, the services sector is beginning to recover. According to the International Monetary Fund's July 2021 forecasts, the world economy will grow by 6.0% in 2021 and by 4.9% in 2022. The rapid economic recovery has been made possible by unprecedented monetary and fiscal support measures. As a result, in the medium term, euro area GDP could recover close to the pre-COVID-19 growth trajectory, while in the US in 2023 GDP could be even higher than projected before the COVID-19 pandemic. However, the economic recovery is currently uneven, with unexpectedly high industrial demand and supply chain disruptions leading to shortages of certain goods, delays in supplies and rising costs.

However, countries with high vaccination rates, such as the United Kingdom or Israel, now have significantly lower hospitalization and mortality rates than in previous COVID-19 waves. As the virus becomes less dangerous, the need for various restrictions and the associated negative effects on the economy also diminish. In the Baltic months, and especially in Latvia, a new wave of COVID-19 is possible in the autumn months of this year, as vaccination rates are still well below the EU average. This could mean new constraints on the economy. At the same time, the rise in COVID-19 in ASEAN and the outbreaks of the virus in China with relatively low vaccine coverage and the 'zero COVID' strategy have put new constraints on a region important to global industry. This could lead to even greater disruption of the production and supply chain, and cost pressures.

Disruptions to the supply chains and high demand have led to significant increases in the prices of natural resources, various goods and transportation casts around the world. Since mid-2020, global oil prices have risen from about $ 30-40 a barrel to about $ 70 a barrel. Food, metals and timber prices have also risen sharply. At the same time, coordinated monetary and fiscal expansion has raised concerns about potential persistent inflation in the longer term. The good news, however, is that historically increases in global resource prices have not led to sustained increase in inflation. In addition, rising resource prices have stabilized since the beginning of the summer. Oil prices have fallen below $ 70 a barrel again, world food prices have fallen by 3.8% since May, and timber and metals prices have decline sharply. However, a longer period of higher global inflation cannot be completely ruled out. Global industry is still experiencing supply chain disruptions, with prices continuing to rise and unemployment falling sharply. However, the risk of inflation is more pressing in the United States, where inflation has so far been more pronounced than in the euro area or China, where inflation, excluding energy and food prices, remains low.

Unprecedented fiscal and monetary support measures have helped the global economy recover from the economic downturn caused by the COVID-19 pandemic, but governments are now beginning to reduce fiscal deficits and rising inflation is increasingly prompting central banks to limit monetary support measures. The opening up of service sectors following the lifting of COVID-19 restrictions will certainly contribute to further economic recovery, but in other sectors demand is very high and is likely to weaken. For example, in the US economy, this is the first recession in history to see an increase in consumption of durable goods. Neither producers nor traders expected this situation at the beginning of the pandemic. This, together with the physical disruption of production and logistics caused by COVID-19, has significantly reduced the level of inventories of many goods. As a result, global industry is currently trying to meet both current demand and rebuild stocks. The inventory rebuilding cycle is likely to continue until the first half of 2022, but this may be followed by a weakening of demand. At the moment, although the growth rates are very fast and their normalization is not surprising. In recent months the economic data in the major economies have become less positive and are increasingly weaker than analysts have predicted. Such negative economic surprises often signal a change in general sentiment and it cannot be ruled out that the global macroeconomic outlook could start to deteriorate by the end of 2021.

Strong external industrial demand and growing global trade, the partial lifting of Covid-19 restrictions and fiscal measures to support the economy have also contributed to economic recovery in the Baltic region. Business sentiment in the Baltics is strong and GDP is already above pre-crisis levels. In the 2nd quarter of 2021, Latvia's GDP increased by 10.3% year-on-year. Meanwhile, in Lithuania, GDP grew by 8% in the second quarter, while in Estonia, in the first quarter of 2021, annual growth exceeded 5%. As a result, the Latvian economy has returned to pre-Covid-19 levels, although in the first quarter of 2021 the Latvian economy lagged behind Lithuania and Estonia. This is due to a further decline in the Latvian transit sector, lengthier Covid-19 relate restrictions in retail trade and the successful operation of some Lithuanian and Estonian companies. However, some service sectors are still affected by constraints, vaccination rates in the Baltic States are lower than the EU average, and positive growth rates generally say little about the strength and resilience of the Baltic economy and its growth potential after the end of state aid measures. Despite the second wave of COVID-19, the macroeconomic forecasts of the Baltic States have not changed significantly since the end of 2020, but the planned government budget deficit and debt level have increased.

Manufacturers in the Baltics are currently feeling strong demand in the global manufacturing, as demand in some industry segments exceeds supply. As a result, inventory levels have fallen, deliveries of goods has been delayed, and freight and transport costs have risen. This is not good news for consumers, but for the Baltic producers it means new orders, which have grown significantly in the first 6 months of this year. In June 2021, manufacturing output in Latvia increased by 10.9% compared to June 2020, while manufacturing growth in Lithuania reached 21.2% and in Estonia 10%. In June, as in previous months, positive annual growth was recorded in almost all sub-sectors of industry, and in most production volumes have already exceeded the pre-COVID-19 peak. The rapid growth of production volumes has been one of the factors that has also contributed to the overall economic recovery in the Baltics. However, the proliferation of the COVID-19 delta variant in the countries of South-East Asia, as well as in China, has had a negative impact on their industries and port operations, and global industrial and supply chain problems may become even more acute later this year. This suggests that the recovery cycle and industrial growth in the world could continue at least until the beginning of 2022, and this is good news for Baltic producers.

With the easing of COVID-19 restrictions, retail sales in the Baltics have returned to previous levels and continue to grow. In June 2021, the retail trade turnover at constant prices in Latvia was by 5.9% higher than a year earlier, while in Lithuania and Estonia it was by 15.3% and 12.2% higher, respectively, than in June 2020. The growth of trade in the Baltics in 2021 has been facilitated by both the limited availability of services and the fiscal economic support measures as well as the relatively good situation in the labor market, as a result of which the income of the population continues to grow. So far in 2021, retail trade in Latvia has lagged behind Estonia and Lithuania due to stricter restrictions and a slightly weaker general economic recovery. Our customers' credit card data show a further increase in consumption in Lithuania and Latvia in July and August. At the same time, during the COVID-19 pandemic, Baltic households and businesses have significantly increased their deposits with commercial banks, which could boost consumption in the second half of the year.

Restrictions due to Covid-19 have been reduced, but they still have a significant impact on certain service sectors, such as hotels, restaurants and entertainment. Covid-19 related requirements have also hampered international travel, and the number of foreign tourists in 2021 is still more than 80% lower than in 2019. Thus, the summer foreign tourism season in 2021 is even weaker than in 2020. However, the situation is better in other service sectors. Local tourism is growing, and Covid-19 has not significantly affected, for example, exports of business and IT services, which continue to grow. However, Latvia's exports of services will continue to lag behind Lithuania and Estonia in 2021, which is mainly due to a further decline in transit cargo volumes. At the same time, Lithuania has made progress in the development of financial technology industries, and Vilnius is increasingly becoming the Baltic financial center.

The construction industry in the Baltics has not been significantly affected by the restrictions of Covid-19, and in 2021 construction is expected to grow. The measures taken by the countries to support the economy and the sufficiently high activity in the private sector, especially in the construction of residential buildings, have contributed to a rapid improvement construction sentiment in the second quarter of 2021. The industry is currently most constrained by a shortage of materials and rising construction costs. In the 2nd quarter of 2021, the cost of construction materials in the Baltics increased on average by 6-11% compared to the previous year, although in some product categories, such as lumber, the increase was significantly higher. The prospects for construction development in the coming years are also positive. Activity in the real estate market in the Baltics is high and real estate prices are rising, and from 2022 the investments of the EU Economic Recovery Fund will start to flow into the Baltic States while the construction of Rail Baltica is expected to gain momentum. In addition, the EU Economic Recovery Fund has allocated significantly more funding to Latvia than Lithuania or Estonia. This means that there is also a certain risk of overheating in construction in the coming years, as the COVID-19 pandemic also has limited opportunities to attract foreign workers.

Despite the second wave of COVID-19, the situation in the Baltic labor market is relatively good. In the second quarter of 2021, the unemployment rate reached 7.9% in Latvia, 6.9% in Estonia and 7.4% in Lithuania, compared to the EU average of 7.7%, while wages continue to rise. However, the overall situation is unclear, as labor market is affected by Covid-19 constraints and various government support measures. In 2021, household income in Latvia has increased, but mainly due to one-off benefits. At the same time, despite existing constraints and the still high level of unemployment, labor shortages are once again becoming a major constraint on growth in almost all sectors. This suggests that unemployment margins may be lower than expected, but the real situation in the labor market will only be fully assessed once all restrictions and state aid measures have been lifted.

As in the rest of the world, the recovery of the Baltic economies has coincided with rising inflation, but headline consumer price inflation remains modest, driven mainly by external factors such as energy and food prices. In July, consumer prices in Latvia increased by 2.8% compared to July 2020, while in Estonia and Lithuania prices increased by 4.9% and 4.3%, respectively. Of course, the prices of certain goods and services have grown much faster and the prices of construction materials are not included in the consumer price index. Consumer prices are likely to continue rising in the second half of 2022, as global price increases are passed on to domestic prices. For example, electricity and natural gas prices in the Baltics have risen in recent months. The cold winter, hot summer and economic recovery, especially of industry, from the COVID-19 pandemic crisis have increased electricity demand. In addition, the prices of carbon emission allowances in Europe have risen significantly this year, making gas and fossil fuel energy more expensive. At the same time, the weather this summer has been less favorable for the production of existing renewable resources in our region, but transmission interconnection capacities with Sweden and Finland are limited. This, together with the still difficult situation in global production and logistics, suggests that external factors will continue to put upward pressure on prices in the Baltics. At the same time, labor shortages in manufacturing, construction and services point to further upward pressure on wages, which could also contribute to higher service price inflation. At present, domestic service price inflation remains low, but risks to faster growth certainly exist.

Investment from the EU Recovery Fund, the lifting of remaining COVID-19 restrictions and the recovery of the services sector, as well as significant household savings and strong external demand, will continue to support the recovery of the Baltic economy. The global macroeconomic outlook is very positive, but global growth is currently driven by unprecedented monetary and fiscal support measures. Rising inflation rates will increasingly lead to a reduction in these support measures, and the reduction of fiscal deficits in the Baltics may be more painful than currently thought. At the same time, EU fiscal rules have been suspended until 2023, and Baltic households have accumulated significant funds during the COVID-19 pandemic, which could flow into the economy as restrictions ease. Also, investments of the EU Economic Recovery Fund will start to flow into the Baltics next year, and if the restrictions ease, the service sectors could give a one-time 3-4% increase in GDP.

The COVID-19 pandemic remains a risk to the economy, although experience in other countries shows that vaccines significantly reduce the risk of serious illness and mortality. Unfortunately, the coverage of COVID-19 vaccination in the Baltics is one of the lowest in Europe and lags far behind its neighbors, so new virus outbreaks and economic constraints are possible in the autumn. However, the economy as a whole is in a very strange situation. The COVID-19 pandemic is hopefully coming to an end, with the global economy growing at a rapid pace, but this is achieved with the help of very extensive support measures. At the same time, there is considerable potential for recovery in the services sector, but rising inflation is increasingly prompting central banks and governments to reduce support measures. Meanwhile, consumption of electrical goods, construction materials and some other durable goods is currently very high and could decline as the services sector recovers. Uncertainty about deliveries in the autumn, as well as the winter shopping season, forces traders to place larger orders than necessary. In the short term, this further increases demand and exacerbates supply problems, and industrial orders continue to grow. Therefore, the normalization of the global production and supply system will take time and may not take place until next spring. However, inventory levels could be restored next year, which could mean a decline in demand in global industry. The possible slowdown in the global industrial cycle at the end of this year, as well as at the beginning of next year, is already signaled by the decline in Chinese producers' sentiment in recent months and the slowdown in credit impulse. In recent years, this has signaled a weakening of global production demand over the next 9-12 months. Measures to support the advances economies are also being reduced, so the risk of overheating the wage inflation spiral seems small to me at the moment. However, a longer period of inflation cannot be completely ruled out, which could force central banks to limit their support measures more sharply. At the moment, there is no reason to think that growth in the Baltics will not continue. Growth will certainly slow down, but the slowdown is from a very high growth rate, but the economic growth forecasts for 2022 in the Baltics may turn out to be too optimistic.