Baltic economic overview 11/2023

Global economic environment remains challenging.

In 2023 global economy has continued to grow despite numerous challenges and an uncertain outlook. On the positive side, rising interest rates have helped to reduce inflation, energy prices have declined, and recession has been avoided. However, growth in the euro area remains weak as GDP in euro area in Q3 2023 grew by only 0.1% compared to same period in previous year, global trade is shrinking and business sentiment in euro area is in negative territory. According to the Bloomberg consensus forecasts, in 2023 GDP in the euro area is projected to grow by only 0.5%, and it is expected to remain low in 2024 with GDP growing by just 0.7%. In the U.S. economic growth has been stronger than expected and in 2023 U.S. is expected to grow by 2.3%, although growth is projected to slow to 1% in 2024. Both US and euro area manufactures remain cautious on new orders, but producers are reporting an ongoing decline in stocks of produced and unsold goods. This decline will eventually lead to gradual expansion of actual production, and in the case of euro area manufacturing could start to gradually increase production levels in 2024 Q1. At the same time unemployment remains low and declining inflation will be positive for consumption growth. However rising interest rates will continue to weigh on construction and housing markets, geopolitical tensions remain high, and China continues to struggle with problems in housing market.

Inflation in euro area has declined due to lower energy prices and falling producer prices. 

In October, inflation in the euro area slowed to 2.9%, reaching its lowest level in 27 months (since July 2021). Leading indicators suggest that inflation in the euro area will continue to slow. For example, in September 2023, the producer prices index in Germany decreased by almost 15% year-on-year, marking the largest decline since 1949. In the absence of negative surprises, such as new geopolitical escalations, euro area inflation is likely to be close to 2% at the beginning of 2024. At the same time, energy prices in Europe remain high despite nearly full natural gas storage. Due to limited supply, natural gas futures prices are projected to return to normal levels only in 2026 when global large LNG export capacity projects, currently under construction, are expected to be completed. In addition, core inflation excluding energy and food prices remains well over 4% in the euro area and will take longer to reach the ECB target of 2% due to tight labour markets and substantial fiscal deficits, which are partially offsetting the tightening of monetary policy.

Interest rates in euro area have peaked and first rate cut is expected in the first half of 2024.

After a period of very rapid monetary policy tightening, ECB interest rates have reached their highest level since 1999. Monetary policy affects real economy with long and variable lags, and in recent years during the period of very low interest rates households and business in euro area have increasingly favoured the use of fixed rate loans. As a result, debt service costs in euro area have not increased as fast as ECB policy rates. As inflation in euro area has slowed significantly and economic growth in euro area remains very sluggish financial markets are anticipating the first interest rate cut to happen already by the mid-2024 with more than 50% probability that it could happen already in April 2024. At the same time interest rate cuts are likely to be gradual. Rising long-term interest rates suggest that over the medium to long term, interest rates are likely to be higher than in the previous decade.

Euro area growth prospects remain weak despite cheaper energy and falling inflation.

Rising interest rates, weak global manufacturing demand and slow recovery in China, as well structural competitiveness issues due to high energy prices and switch to electric vehicles continue to weigh on growth in euro area. Since spring 2023 economic sentiment in euro area has deteriorated as rebound in services has faded while manufacturing and construction remains in negative territory. Construction sector in particular is increasingly feeling the impact of higher interest rates especially in housing and commercial real estate markets. As a result, share of German construction companies reporting insufficient demand has reached 2008 levels. At the same time first positive signs have emerged in manufacturing where companies indicate the start of the so-called destocking cycle. For example, survey conducted by the EU Commission indicates that stocks of unsold goods in German industry are decreasing for the fourth month in a row. As inventory levels decline this should lead to increase in new orders and growth in manufacturing output.

Baltic region is already in a mild recession.

Inflation, high energy prices, falling real incomes, weak external demand in manufacturing, and rising interest rates have hit GDP growth in the Baltics and all three Baltic countries have had at least two consecutive quarterly declines in GDP. In the Q3 2023, Latvia's GDP declined by 0.1% compared to the same period in 2022, while Lithuania GDP remained unchanged and Estonia in Q2 2023 GDP fell by 3%. Due to weak external demand, the output in the industrial sector has declined in all three Baltic countries, while the service sectors have mostly continued to grow. Leading indicators show contrasting economic trends in the Baltics region. On one hand, data suggests that economic activity has started to pick up in Lithuania, mostly driven by improving optimism in the manufacturing sector. In contrast, in Latvia economic sentiment has remained stable in recent months while in Estonia the October economic sentiment index posted weakest reading in 40 months. In our opinion, Estonia is under-performing relative to other Baltic countries due to its higher private sector debt levels and bigger proximity to Scandinavian economies which are suffering severe downturn in construction sector.

High share of variable rate mortgages has led to surging debt service costs in the Baltics.

Loans in the Baltics are mostly issued with variable rates resulting in a faster response to monetary policy tightening compared to other countries. Higher private sector debt level is one of the reasons Estonia's GDP has declined more than Latvia and Lithuania. In Lithuania and Latvia private sector debt levels are among the lowest in the euro area and as a result debt service costs have risen only modestly, although impact on individual borrowers can be significant. Low debt levels, use of variable rate loans and relatively healthy housing cost-to-income ratio has allowed new lending in the Baltics to continue despite high interest rates. Quick response to monetary policy changes also means that the expected interest rate cuts in will support economic recovery starting from mid-2024.

Construction sector sentiment in the Baltics remains stable despite higher interest rates.

Construction is one of the sectors that is most sensitive to rising interest rates and construction sector outlook for 2024 is very uncertain. Share of German construction companies that report lack of demand has reached the highest level since 2008, new construction permits in euro area are declining, while house prices are falling in a number of countries. Yet, at the same time new mortgage lending in the Baltics continues despite higher rates as lending volumes remain well above pre-pandemic levels. Part of new lending in 2024 is a result of delayed effects from recently completed construction projects as purchase agreements had been signed before the construction was finished. Housing prices in the Baltics are stabilizing but are not falling apart from some market segments, while construction sentiment in Lithuania and Latvia remains stable and does not suggest a downturn in construction sector in the near term. Some of the resilience in construction sector could be related to strong public sector demand which is driven by availability of the EU financed investments.

Declining inventory levels point to a potential upturn in manufacturing in 2024.

Weak global demand and the relatively high level of goods inventory, accumulated in many industrial sectors worldwide since the end of the pandemic, have negatively impacted Baltic manufacturing in 2023 and industrial output has been declining for more than a year. At the same time first signs of stabilization in euro area manufacturing have emerged as inventory levels have begun to decline. Declining inventory levels eventually lead to gradual expansion of production, and this points to a potential upturn in in 2024. Currently positive trends are more visible in Lithuania, but Latvian and Estonian manufacturing sector are likely to follow suit soon. However, the recovery in the industry next year is expected to be gradual. Growth prospects in the world economy are uncertain, growth in euro area has stalled, in the US recession remains possible, and the rapid rise in interest rates has significantly reduced activity in construction sector. And sharp decrease in producer prices in euro area will put pressure on Baltic manufacturers to cut the prices of the goods/components they are producing for the European clients. Price cuts, especially when selling unsold products, can create additional financial pressure on manufacturing companies.

High inflation has weighed on retail sales, but consumer confidence is improving.

Wages in the Baltics continue to grow, unemployment remains low and inflation is falling rapidly. However, in the last two years, consumer prices in the Baltics have increased by more than 25% and income growth has not been able to keep up with inflation. This is reflected in relatively weak retail sales figures in 2023 as sales volumes have declined in all three Baltic countries. Inflation has reduced consumer purchasing power and income growth has not yet caught up with recent price increases. At the same time loan payments have increased due to interest rates while pandemic era excess savings have been largely depleted. As a result, we see that household deposit growth in banks is slowing, while the issuance of consumer loans is increasing. Meanwhile consumer optimism trends in the Baltic region remain contrasting. In the case of Lithuania and Latvia, consumer confidence levels are close to the highs that were last seen several years ago, with consumer optimism mainly driven by slowdown in inflation. However, as of recently, consumer confidence in Lithuania stabilized and has stopped improving, as consumer are becoming a bit more cautious on their financial situation, savings and economy. In the case of Estonia, consumer confidence remains weak, in line with weaker performance of Estonian economy.

Export service sectors have continued to grow, but tourism has not reached pre pandemic level.

In 2023 service sectors in the Baltics have mostly continued to grow and service sector confidence has remained stable in Lithuania, and Latvia while declining slightly in Estonia. Domestic service sectors continued to recover the impact of COVID-19 pandemic while export orientated professional and IT service sectors continue to grow. At the same time transport sector has been hit by downturn in manufacturing and weaker exports, and tourism so far has not reached pre pandemic level as number of foreign visitors remains 18-34% below 2019 level. Partially this is due to lower number of tourists from Russia and Belarus, but number of Scandinavian and German tourists also remains below 2019 level.

Wage growth in 2023 has exceeded 10% and unemployment is low, but labour demand is weakening.

Labour market in the Baltics remain resilient despite declining GDP. Average wages in the Baltics in first half of 2023 have grown by more than 12% compared to the previous year. Unemployment levels in Latvia and Lithuania remain near record lows, while in Estonia weaker economic growth has caused an increase in unemployment. At the same time there are some signs of weakening in the labour market. Share of companies reporting lack of labour as significant obstacle to growth has declined, unemployment in Estonia has increased slightly especially in manufacturing and some parts of services sectors such as starpups where rising interest rates have reduced access to financing, and number of vacancies has decreased. Over medium to long term labour markets in the Baltics will remain tight as number of people of working age in the Baltics is decreasing and the lack of labour remains a significant obstacle to economic growth.

Increase in public sector investments and rebound in manufacturing will support GDP growth in 2024.

In 2024 GDP growth in the Baltic countries is expected to resume, but at a relatively moderate pace of 2.3-2.6%. In manufacturing we see signs that destocking cycle is nearing the end, and manufacturing is likely return to growth in 1H of 2024 although strength of the recovery is probably going to be modest. Inflation in 2024 is expected to average near 2.5% while we expect wage growth to slow from more than 10% in 2023 to 6.4-7.5% range in 2024. Thus real incomes will grow again and this will support consumption growth. In addition, loans in the Baltics are mostly issued with variable rates, and as a result Baltic region has already felt the impact of monetary policy faster than other countries. Interest rates cuts that are expected to begin by mid-2024 will then start to support economic recovery. Finally, weak private sector demand in construction in 2024 will be partially offset by EU funded increased public sector investments and fiscal policy in general remains accommodative as countries continue to run budget deficits.

Outlook remains uncertain and subject to a number of significant risks.

The war in Ukraine continues and geopolitical tensions remain high and have increased even further due Israel-Palestinian conflict. China's economy continues to struggle with problems in the property sector, in euro area short-term indicators and economic sentiment have deteriorated despite falling inflation and natural gas prices remain elevated despite almost full natural gas storage. New supply disruptions or unexpectedly strong demand due to cold winter could lead to new energy prices spikes. In addition, long and variable lags rapid rate of monetary policy tightening could cause a more significant economic slowdown than currently expected. And rapid rise in long-term rates could cause financial stability risks in euro area or globally due to high debt levels. Finally, growth in euro area is hampered not only by cyclical factors, but also by structural factors such as high energy prices and increased competition in critical sectors such as automotive manufacturing.

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