Baltic economic overview 03/2024

Global economy has exceeded expectations in 2023 despite recession forecasts at the start of year. In the U.S.

GDP growth in 2023 reached 2.5%, and leading indicators also point to stabilization in the euro area. According to International Monetary Fund January 2024 forecast global economy in 2024 is expected to grow by 3.1% which is 0.2% higher than forecasted in October 2023, despite elevated geopolitical tensions, ongoing war in Ukraine and high interest rates that continue pose challenges to global economy. In the euro area growth remains weak and GDP is forecasted to grow by only 0.9% in 2024 as growth prospect remain constrained by interest rates, still high energy prices relative to US and negative impact from geopolitical tensions. Large fiscal deficits have helped to mitigate economic slowdown, although over medium-term fiscal deficit risk contributing to inflation and lead to higher interest rates.

Economic growth in the euro area in 2023 has been noticeably weaker than in the US.

In 2023 GDP in euro area increased by only 0.5%, however in recent months leading indicators such as PMIs and EU Commission economic sentiment data suggest that euro area economy has reached the bottom and has started to stabilize in most euro area countries. The positivity is largely driven by manufacturing sector, where companies are reporting a steady decline in stocks of unsold goods. Data suggests that destocking process has started in the euro area manufacturing sector and this is expected to lead to recovery in the manufacturing and transport sectors. Meanwhile construction sector remains a notable weak spot in the euro area economy, largely due to high interest rates and high debt levels that has led sluggish private sector demand, and weak housing markets while shift to hybrid working patterns since COVID-19 pandemic have reduced demand for offices. German construction companies in particular have reported record levels of insufficient demand, however even here there are tentative signs of stabilization as the share of companies reporting lack of demand has started to decline.

Demand in manufacturing remains weak and industrial production in euro area in 2023 declined by 2.4%.

High inflation and shift in consumer demand towards services has contributed to weak demand for goods in both euro area and the global economy since the end of COVID-19 restrictions. This has led to rising levels of inventories in manufacturing and subsequently a decline in new industrial orders. Nonetheless, recent developments indicate a positive change to the growth outlook. EU Commission survey data indicates that inventory levels in euro area manufacturing have peaked, and destocking process is gaining pace. In January 2024 stocks of unsold goods in the euro area manufacturing declined to the lowest level in 9 months, while stocks in German manufacturing hit the lowest level in 8 months. In Germany number of trucks driving on roads also rose in February, which is a positive leading indicator for manufacturing trends in the euro area and positive signal for Baltics industrial companies. This is already visible in Lithuania where stocks of unsold goods in manufacturing sector have declined for the last 2 months. Despite these positive developments, the recovery in manufacturing is expected to be moderate and uneven, particularly due to weak demand in construction sectors. Industries such as manufacturing of building materials and others sectors related to construction are unlikely to fully benefit from the demand recovery in 2024.

Inflation in the euro area has declined rapidly since the beginning of 2023 to below 3% at the start of 2024.

This has led to financial market expectation of a rapid reduction in interest rates in 2024. However, the timing and pace of interest rate cuts will depend largely on inflation trends, particularly the performance of domestic inflation. Inflation expectations in euro area have decline in line with inflation itself, but expectation have stabilized at relatively high levels, indicating that inflationary pressures within the euro area remain substantial. In the short-term inflation in euro area is likely to fall further driven by declining producer prices. At the same time core prices, which exclude energy and unprocessed food, have also stabilized and have not increase since mid-2023. Historically, domestic prices are often reset at the start of the year as companies adjust their financial plans, typically increasing prices in the first four months before stabilizing and remaining broadly unchanged for the remaining part of the year. Yet, this predictable pattern has been disrupted since 2021 and future path of inflation uncertain. 

Interest rates in the euro area most likely have already peaked and EURIBOR could decline below 3% by the end of the year, according to financial market forecasts.

However, current financial market outlook is more optimistic than that of central banks. Strong labour market data and higher than expected January inflation has already reduced number of expected interest rates cuts in 2024 from 7 to approximately 4 in both U.S. and euro area. In recent months ECB has somewhat shifted its focus in regard to rates decision from inflation data to wages data as domestic inflationary pressures continue, and interest rate cuts are unlikely to commence until central banks are confident that inflation has fallen below 2%. That means ECB is likely to wait for inflation data from the first four months of the year before deciding on potential interest rate cuts, thereby delaying the date of the first interest rate cut to June 2024. Over the medium-term financial markets anticipate that interest rates will remain higher over than in the decade before COVID-19 pandemic. According to financial markets long term interest rates in the U.S. could be around 3.5% and 2-2.5% in the euro area. Return to very low or zero is unlikely in the near term unless there is a significant deterioration in the economic outlook.

Declining global commodity prices and fall in transport costs have helped to reduce global inflation.

Since 2022 Europe has successfully replaced natural gas imports from Russian with imports from Norway, the US, Qatar, and other countries and by increased use of alternative energy sources. Despite the significant decline in energy prices, energy prices in Europe remain substantially higher than those in the United States which poses a considerable challenge to the competitiveness of the European manufacturing sector. Besides energy prices in Europe, global commodity prices have also been on a downward trend since mid-2022 contribution to a decline in global inflation. However geopolitical risks could pose a threat global economy in the near to medium term. Recent attacks by Yemen rebels in the Red Sea have resulted disruptions in traffic through the Suez Canal and together with drought related disruption in Panama Canal have led to higher transport costs. If this situation will persist it could potentially lead to new inflationary pressures.

Weak global oil demand has been one of the main factors contributing to the decline in global commodity prices since the middle of 2022.

World oil consumption in 2023 was slightly above 100 million barrels per day which is well below growth trend observed before 2019. To offset weak demand and support oil prices Saudi Arabia has implemented oil production cuts. However, these cuts have been offset by record oil production in the United States. As a result potential for significant oil price increases in the near term appears to be limited even if global economic growth were to accelerate as it would take some time for global markets to absorb the unusually large OPEC spare production capacity. On the contrary, if Saudi Arabia were to increase oil production in an attempt to regain market share as it did in 2020 oil prices would most likely decline. 

China continues to struggle with problems in the real estate market, despite relatively stable growth outlook.

According to analysts surveyed by Bloomberg, GDP growth in China in 2024 and 2025 is expected to be close to 4.5%. Despite this, several key indicators point to a significant slowdown in the Chinese economy. Both consumer and producer price inflation has turned negative, and export prices are declining rapidly. In addition, the Chinese stock market indices have declined by more than 30% from 2021 highs, with no sign of a potential rebound despite significant stimulus measures implemented by Chinese authorities. Deflation increases real value of debt in China, further complicating debt issues and such debt deflation dynamic often result in prolonged periods of weak growth as companies and households prioritize balance sheet repair and debt reduction over investment. The weakness in the Chinese economy is likely one of the key reasons why global oil demand has remained flat over the last couple of years and why global commodity prices have been declining since the middle of 2022. In the short term, this trend has helped to reduce inflationary pressures in Western economies. However, problems in the Chinese economy also have one of the reasons behind weak export performance in Germany and, consequently, the weakness in European manufacturing as a whole. To deal with debt problems China needs to rebalance the economy away from investment and construction towards consumption, since previous strategy of increasing exports and increasing global market share in manufacturing is unlikely to work as Western countries increasingly adpot more trade protectionist measures.

In 2023 growth in the Baltic region was negatively affected by high inflation, rising interest rates, weak external demand in manufacturing and the ongoing impact from the war in Ukraine resulting in moderate recessions across all three Baltic countries.

In Lithuania and Latvia, GDP decreased by 0.3% in 2023, in Estonia by 3%. Overall GDP in the Baltic region has not grown since beginning of 2022 although performance of different sectors of the economy has been very varied. Manufacturing and transport sectors were the hardest hit in 2023, largely due to weak external demand and a cyclical downturn in global manufacturing. Agriculture also suffered due to unfavourable weather conditions and declining prices, while the retail trade sector struggled with falling real incomes caused by high inflation and a high share of variable rate loans. However, service sectors such as IT, professional services, and tourism continued to grow. In 2023 GDP growth in Estonia was lagging Latvia and Lithuania, primarily due to Estonia’s higher trade exposure to Sweden and Finland. Additionally, rising interest rates had a significant impact on consumption and investment, particularly due to the larger private sector debt and a substantial IT startup sector where higher interest rates led to reduced availability of funding – both interest rate sensitive sectors. Despite the continued uncertainty and significant risks, overall growth prospects for the Baltic region in 2024 appear more favourable compared to 2023 as economic sentiment indicators have stabilized and begun to improve slightly in Lithuania and Latvia.

Signs of stabilization have emerged in the manufacturing sector in recent months, following a decline in output in 2023.

European Commission business surveys show suggest that inventory levels in the Baltics manufacturing sector have peaked and destocking cycle in Europe will play a crucial role in the recovery of the manufacturing and transport sectors in the Baltic region. As inventories decline this will lead to new industrial orders, and survey data already suggest Lithuanian companies are already reporting insufficient level of stocks of goods in warehouses and continue raising their production forecasts. For example, In January expectations about manufacturing output in Lithuanian industry sector reached 12-month high. Even so, recovery is expected to be moderate and uneven across manufacturing sectors. For instance, demand in the construction sectors of Germany and Sweden remains weak due to the impact from high interest rates. For example, in Sweden new dwelling starts in construction have fallen to a multi-year lows. As a result, while overall demand in manufacturing is expected to increase, it will not be uniform across all sectors simultaneously and manufacturers of building materials, wood products, and certain segments of the metal products, are unlikely to experience significant demand growth in 2024.

Construction sector has become the weakest link in the euro area economy.

High interest rates and elevated debt levels have dampened demand in housing sector while changing work patterns have had negative impact on the demand for offices. At the same time in the Baltics demand in the construction sector remains relatively stable. Although activity in the real estate markets have also declined somewhat, debt levels in the Baltics are significantly lower than in euro area while government investments are set to increase in all three Baltic countries throughout 2024 and 2025 supported by increased inflows from EU recovery fund and regular EU funds. Additionally, Baltic region has ambitions plans in the energy sector, particularly in Lithuania and Estonia, that will further support demand in construction sector. Despite some uncertainty surrounding funding construction of Rail Baltica project will also continue in the Baltics and as a result construction sentiment in the region remains stable and the outlook for the sector is more positive compared to the euro area.

In 2023 retail sales in the Baltics stagnated and growth was driven only by inflation.

In real terms, retail sales in the Baltics have remained unchanged since the middle of 2021 due to high inflation and the reopening of service sectors after the end of COVID-19 restrictions as a result of which spending on leisure activities, restaurants, and travel increased. Even so, inflation in the Baltics has declined rapidly from around 20% at the start of 2023 to less than 2% in Lithuania and Latvia, and close to 4% in Estonia. As result consumer sentiment in Latvia and Lithuania has improved notably in recent months. As inflation continues to decline, real incomes are expected to begin to increase again, which will have a positive impact on retail sales and overall consumption trends in 2024. The rapid increase in inflation in 2022 and 2023 resulted in a situation where the prices initially increased much faster than incomes. As a consequence spending growth in 2023 was very weak, household deposit growth in the banking sector stalled and to sustain higher spending levels households increased the use of consumer credit. However, now there are signs that income growth, which remained robust in the Baltics in 2023, is starting to catch up to the new price levels. As inflation continues to decline, continued income growth should gradually translate into stronger retail sales.

Situation in labour market in the Baltics remains stable, although weak economic growth is noticeable.

In Estonia, unemployment increased from an average of 5.6% in 2022 to 6.4% in 2023, in Lithuania unemployment increased from 6.0 to 6.9%, while in Latvia unemployment decreased from 6.9% to 6.5%. In Latvia since the middle of 2022 number of job advertisements and vacancies has decreased by almost half. Across all three Baltic countries business surveys show significantly lower proportion of companies than in 2022 mention the lack of employees as the main factor limiting development and the biggest challenge for businesses now is weak demand, especially in industry, trade and logistics. Despite this unemployment level in the Baltics remains at historically low levels and wage growth in the Baltics exceeded 10% in the first three quarters of 2023. Adverse demographics, shrinking working-age population, high inflation and income convergence with European levels have continued to drive strong wage growth in the Baltics even in the absence of any economic growth. In the medium term, current wage growth rates are unlikely to be sustainable, as the wage share of GDP in the Baltics has already exceeded the EU average. So far this has not yet had a negative impact on the competitiveness of the Baltic region and exports have declined in line with world trade, but this is definitely not sustainable over the medium term. In 2024 wages in the Baltics are expected to continue to grow, especially as governments have planned significant increases in wage spending in national budgets. For example, in Latvia, the wage bill in the public sector is set to grow by more than 10% in 2024. In recent years labour supply in the Baltics has increased due to refugees from Ukraine and positive net migration in Lithuania and Estonia, to a lesser extent in Latvia. However, this is a one-off event, and demographic trends will continue to dominate the labour market in the medium to long term.

Our growth outlook for the Baltic region in 2024 remains cautiously optimistic.

In our view growth in the Baltic region in 2024 will be supported by a recovery in manufacturing and transport sectors, as well as by rising real incomes that will benefit retail trade and domestic consumption more broadly. In addition, we also expect positive contribution to growth from a rebound in the agriculture sector as 2023 which was relatively weak in both in terms of prices and harvests. At the same time we do not expect significant growth in the construction sector due to the negative impact from high interest rates on private sector demand. Furthermore, there is also some uncertainty regarding the future growth prospects of certain service sectors such exports of IT and business services which in 2023 grew at a slower pace than before. According to our forecasts GDP growth in Latvia and Lithuania will be around 2%, while GDP growth in Estonia is forecasted to be closer to 1% due to a lower base effect from weak growth in 2023. Despite a slight increase in unemployment in 2023, in our view labour markets in the Baltics remain robust and we expect unemployment rates in the Baltics in 2024 to be around 6-7%. Inflation in 2024 will remain low and will be below 2% in Latvia and Lithuania, and between 2 and 3% in Estonia, mainly due to the government's increase in the VAT rate.

Despite positive growth expectations, economic outlook remains uncertain and with significant risks.

Geopolitical situation remains the most significant threat to the Baltic region and potentially could be deter new investments in the region amid concerns over potential Russian aggression against NATO countries. More broadly emergence of new geopolitical shocks could disrupt global growth and lead to a scenario where inflation rises because of higher oil and commodity prices. This would place central banks in a challenging position of needing to lower interest rates while inflation remains elevated. Additionally, elevated debt levels in the euro area and the U.S. could cause financial market turmoil, for example in commercial real estate, or raise concerns about debt sustainability. Domestically adverse demographics, weak productivity growth coupled with strong wage growth could lead to a loss of competitiveness. On the positive, the destocking cycle and rebound n manufacturing could be stronger than anticipated. In addition, deglobalization trends could potentially benefit the Baltic and Eastern European region as region would be attractive destinations for friend shoring investment.

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