The worst have been avoided, but we are not out the woods yet

Spring 2023: Baltic Economic Outlook

2022 – the year of polycrisis

In 2022, the global economy faced multiple adverse and interconnected shocks – the phenomenon newly labelled as polycrisis. The world was still coping with the aftermaths of COVID‑19 pandemics such as supply chain disruptions and excessive economic stimulus, which fueled inflation as “too much money was chasing too few goods”. Russian invasion of Ukraine added fuel to the inflation fire by triggering a spike in global energy and food prices, which exacerbated an ongoing cost‑of‑living crisis. Accelerating inflation, in turn, compelled central banks to hit the brakes and launch aggressive and synchronized monetary policy tightening, which deflated global stock, bond and real estate prices as well as increased borrowing costs for households, businesses and governments.

The aforementioned shocks were pan‑global in nature, but affected each region differently. The EU was strongest hit by an unprecedented energy crisis as it grappled to replace Russian natural gas, oil and coal with alternatives. Emerging economies were strongest hit by the cost‑of‑living crisis as rising prices of essentials, such as food and energy, put unproportionally big burden on lower‑income households and smaller businesses. The United States mostly felt the effect of swift monetary policy tightening as the FED decisively hiked interest rates to cool down an overheating economy. Whereas China was still using zero‑covid strategy to fight COVID‑19 pandemics by locking down millions of its citizens at home, which dampened domestic growth and disrupted global supply chains. The polycrisis dampened global GDP growth in 2022 and increased the risk that the EU might fall into recession in 2023.

Economic winter was warmer than feared

Global economy proved to be more resilient to multiple adverse shocks, which prompted many institutions to lift global GDP growth forecasts for 2023. The United States is demonstrating surprising resilience to adverse inflation and interest rate shocks with labor market remaining red hot. China has also positively surprised the world by making a sudden U‑turn and abolishing its zero‑covid policy in December 2022. The re‑opening of China will give a temporary boost to global economic growth, while the EU is set to benefit from easing supply chain disruptions and re‑emergence of wealthy and spendthrift Chinese tourists. Emerging markets are also holding up well with only a handful of countries experiencing financial or economic distress at the moment. 

Russia’s plan to freeze Europe melted away with warm winter weather and the worst‑case scenario of energy rationing did not materialize. European natural gas and electricity prices have dropped to pre‑war levels easing inflationary pressures and reducing pressure on household, business and public finances. Lower energy prices have also eased inflationary pressures, which in most European countries peaked in end‑2022. European consumers continued spending despite falling real disposable incomes – possibly due to strong pent‑up demand postponed during the pandemic years as well as generous fiscal support measures implemented to shield consumers from the energy price shock. European labor market also remained surprisingly resilient with unemployment rate in the EU staying at record low levels and employment growing. As a result, the EU has managed to narrowly avoid recession in end‑2022 and the outlook for 2023 becomes brighter with the soft‑landing scenario, characterized by gradually declining inflation and moderate economic growth, becoming increasingly plausible.

We are not out of the woods yet

Under the baseline scenario we assume that the EU will narrowly avoid recession in 2023. However, we are not out of the woods yet as the outlook for 2023 remains highly uncertain with minefield of risks ahead of us. The major risk is that inflation can stay higher for longer, prompting central banks to continue tightening monetary policy. Although headline inflation in most European countries have already peaked thanks to lower energy prices, core inflation, which excludes volatile energy and food prices, remains persistently high, signifying that strong and broad‑based inflationary pressures remain. Higher for longer inflation would mean higher for longer interest rates, which would continue to act as a drag on economic growth. Given that the monetary policy transmission to the real economy typically takes two to three quarters, there is a material risk that monetary tightening may cause deeper and longer economic recession. On the other hand, too little tightening may not be enough to cool down inflation which would result in prolonged stagflation scenario, characterized by elevated inflation and stagnating economy, which could extend well beyond 2024. Hence, central banks are walking a tight rope aiming to achieve a soft landing scenario. However, the walk will not be an easy one due to strong winds blowing from all sides. 

Geopolitical risks are unlikely to diminish any time soon. We do not expect that relations between Russia and the West will improve in the foreseeable future, regardless of the course of events in Ukraine. The economic decoupling between China and the West will likely continue as well with Western companies increasingly re‑shoring from China or moving production to other Asian countries. Rising tensions between China and Taiwan also motivates Western companies, fearful of a deja‑vu scenario in Ukraine, to reduce dependence on China. China’s attractiveness is also falling due to rapidly deteriorating demographics, made worse by protracted COVID‑19 lockdowns, which will aggravate an ongoing slow‑motion housing market crisis. Increasing protectionism, de‑globalization and geopolitical tensions also increases risks of the extended period of higher inflation and lower economic growth.
 
Europe has won the first battle of the energy war with Russia, but the energy war is not over yet

Russia has started energy war with Europe long before the Russian invasion of Ukraine. Already in Autumn 2021 European gas storage facilities, owned by Russian state‑owned company “Gazprom”, were left virtually empty. Rising concerns over unusually low European gas storage levels resulted in the first major jump of European gas prices back in October 2022 when prices hit above 100 EUR/MWh. The second jump (to 180 EUR/MWh) was observed in December 2022 after Russia stopped exporting gas to Europe via “Jamal‑Europe” pipeline. The third jump occurred after the start of the Russian invasion of Ukraine when European gas prices increased to 134 EUR/MWh on February 24, 2022. European gas prices remained elevated throughout the whole 2021/2022 winter averaging more than 94 EUR/MWh, which is 5.2 times higher compared to 2020/2021 winter. Higher natural gas prices also increased electricity prices with German electricity prices in 2021/2022 winter averaging 140 EUR/MWh, which is 3.6 times higher compared to 2020/2021 winter (39 EUR/MWh). An increase in natural gas prices allowed Russia to earn record‑high revenues from gas sales at the expense of Europe.

The energy war between Russia and Europe culminated in August 2022 when Russia discontinued supply of gas via “Nord Stream” pipeline. European gas prices temporarily jumped above the 300 EUR/MWh mark. However, since August 2022 European gas prices started to gradually decline thanks to ample gas storage (the 90% gas storage target was met in the beginning of October), reduced gas consumption (in 2022 gas consumption in the EU dropped by 12% compared to 2019‑2021 average levels), increased alternative gas supplies (Europe’s LNG imports increased by 60% in 2022) and warm winter (winter in Germany was nearly 3 degrees warmer than usual). As a result, average European natural gas spot price for 2022/2023 winter was 77 EUR/MWh – much lower than feared and even lower compared to 2021/2022 winter when spot price averaged 94 EUR/MWh. Electricity prices have also declined from record‑heights. Hence, not only the worst‑case scenario of energy rationing was avoided, but Europe managed to get gas prices lower than the previous winter. Europe also managed to preserve unity and keep pan‑European gas and electricity markets running, which in the longer‑term should encourage investments and competition in energy sector.

Europe clearly has won the first battle of the energy war with Russia, but the war is not over yet. The European gas and electricity prices remain 2‑3 times higher compared to pre‑crisis period in 2015‑2019, which negatively affects business competitiveness – especially of energy‑intensive manufacturing companies. European gas and electricity futures indicate that market participants expect natural gas prices to remain within the range of 40‑60 EUR/MWh during the 2023/2024 winter, which is around 3 times higher compared to 2015‑2019 average price levels. Electricity prices are expected to remain 2‑3 times higher compared to 2015‑2019 levels. Hence, it is of crucial importance for the EU to increase investments into renewable energy generation capacity as well as to reduce consumption of imported fossil fuels. This would also help reducing greenhouse gas emissions and could put the EU at the forefront of global green energy transformation. 

Baltic economies have unique opportunity to transform their energy systems from fossil fuel‑based to  renewable‑based ones – just as they have successfully transformed their heating systems replacing natural gas with biofuel. All three Baltic countries, together with Scandinavian countries, are leading in the EU by the share of heat energy produced from biofuels. It is possible that by the end of this decade Baltic countries will be among the EU countries, which produce the highest share of their electricity from renewable energy. Plentiful availability of renewable energy would allow Baltic and Nordic region to gain international competitiveness in the longer term. The Russian energy war against Europe has released the renewable energy genie from the bottle – let’s not miss this opportunity. 

Inflation in Europe will stay higher for longer, but the Baltics will not be leading in inflation front anymore

Although headline inflation in most European countries have already peaked thanks to lower energy prices, core inflation, which excludes volatile energy and food prices, remains persistently high, signifying that strong and broad‑based inflationary pressures remain. Headline yearly inflation in the euro area has reached its peak at 10.6% in October 2022 and gradually declined towards 8.5% in February 2023, but the core inflation continues to accelerate increasing from 5.0% to 5.6% during the same period. The key policy challenge is that while central banks are trying to extinguish inflation fire by tightening monetary policy, governments at the same time are adding fuel to the fire by running accommodative fiscal policy. For instance, many European governments provide overly generous and broad‑based support to households and businesses to shield them from the energy crisis, but in doing so they fuel aggregate demand and extend the price shock for longer period. Rising service price inflation increases the risk of a wage‑price spiral spinning out of control with employees demanding ever higher wages to compensate lost purchasing power due to persistently high inflation. Hence, the risk is rising that inflation in Europe can stay higher for longer despite falling global energy and food prices as well as waning global trade bottlenecks. Correspondingly, interest rates would also remain higher for longer, since it will take longer before inflation comes back to central bank’s targets. 

The situation in the Baltics, however, is different compared to the rest of the euro area. In 2022, annual inflation in the Baltics (19.4% in Estonia, 18.9% in Lithuania and 17.2% in Latvia) was the highest in the EU and significantly exceeded euro area average (8.4%). However, the pace of price increase in the Baltics is unlikely to remain substantially higher than euro area average in 2023, while there is high probability that in the end of 2023 it will get lower. To understand why, we need to look deeper into the underlying driving forced of inflation in the Baltics and in the euro area. Food and energy take up the larger share of consumer basket in the Baltics compared to the euro area average (40% vs. 26%), whereas services take up the smaller share (27% vs. 44%). Hence, sharp increase in energy and food prices in 2022, to a large extent caused by Russian invasion of Ukraine, raised overall inflation in the Baltics substantially more compared to the euro area average. However, the tables will turn in 2023 as energy prices are forecasted to fall, food prices – to stabilize, and prices of services – to keep rising even faster. Moreover, in 2022 energy prices in the Baltics increased substantially more than euro area average (56% vs. 37%), since Baltic countries introduced fewer energy price control measures compared to most euro area countries, to a large extent allowing energy price shock to be passed on to final consumers. As the saying goes “the higher you rise, the lower you will fall”, hence energy price deflation in the Baltics this year will be larger than euro area average. This is also partly true talking about food price inflation, since rapid consumption growth allowed food producers and retailers to pass rising production costs to consumers faster compared to the euro area average. Accordingly, falling energy and global food prices gives more space for food price deflation in the Baltics compared to the rest of the euro area. First signs of a price war among retailers is already visible in the Baltics with prices of certain categories of goods falling.

Under the baseline scenario, we forecast that inflation in the Baltics will continue decelerating and will average 7‑9% in 2023 – marked decline compared to 17‑19% growth observed in 2022. Energy prices are forecasted to drop from the peak levels achieved in the second half of 2022, whereas food prices are expected to flatten with some categories of products (milk and bread products) could undergo price corrections. Yet service price inflation is forecasted to remain elevated as wage growth pressures will remain high. Yet the forecasts are clouded by big uncertainty, since inflation dynamics in the Baltics will be more volatile compared to the euro area average due to the higher role played by highly unstable energy and food prices. In case of further drop in energy and food prices, annual inflation can drop below zero by end‑2023 and deeper deflation scenario in 2024 cannot be excluded. Yet, food and energy prices can stay higher for longer. Re‑opening of China may add fuel to global inflationary pressures by lifting global commodity prices – in particular metals and energy. An ongoing Russian invasion of Ukraine may keep volatility of global energy and food prices high, hence one also cannot exclude further spikes in energy and food prices – especially if 2023/2024 winter in Northern hemisphere will be colder than usual.  

Housing market got a cold shower from higher interest rates

Expansionary fiscal and monetary policies during COVID‑19 pandemics fueled housing price increases throughout the world as “too much cheap money was chasing too few houses”. House prices in the OECD countries increased by 36% since the beginning of 2020 – twice as fast as household income (18%) and three times as fast as housing rent prices (12%). As a result, house price‑to‑income and house price‑to‑rent ratios have jumped to the highest levels in at least a half a century. Hence, in 2022 the global housing market was red hot before it got a cold shower from the central banks, which ended the housing market party by aggressively and largely unexpectedly raising interest rates. 

Within the span of just one year the Fed Funds Rate increased from 0.0% to 5.0% – the fastest increase since 1980’s. The ECB followed suite by raising rates from 0.0% to 3.0% since July 2022. Higher interest rates deflated housing prices and dampened housing mortgage activity. In the Unites States mortgage applications fell to the lowest levels in 28 years in February 2023, while house prices are declining since mid‑2022. European housing market have also started to feel the effect of higher interest rates. In the euro area newly issued housing loans dropped by 35% y/y in January 2023, while in Germany the drop was 52% y/y. With interest rates expected to remain higher for longer (3‑month EURIBOR is currently expected to reach the peak at 4.0% in October 2023), the slump in the housing market is set to continue.

The most vulnerable countries are those that experienced an excessive housing price growth during the last decade when money was abundant and cheap. Level of household indebtedness and the share of floating rate mortgage loans also plays an important role. In this respect, Scandinavian countries, having high household indebtedness, high share of floating rate mortgages and excessive housing price growth over the past decade, are among the most sensitive to interest rate increases. In fact, housing price correction is already well under way in all Scandinavian countries with prices in Sweden dropping by 15% in 2022 alone. Slump in housing market activity will reduce demand for houses, furniture and construction materials, which will have negative effect on Baltic manufacturing sector. If interest rates will remain higher for longer, other euro area countries may also experience deep and prolonged housing market slump, especially considering that house price‑to‑income and price‑to‑rent ratios are at multi‑decade heights. 

Baltic region is not immune to global housing market trends. During the last years all three Baltic States have experienced rapid housing price growth, which exceeded household income and housing rent price growth. Between 2019 and 2022 house prices in the Baltics on increased by 42%, whereas wages expanded by 28% and housing rent prices – by 15%. As a result, house price‑to‑income and house price‑to‑rent ratios have deteriorated – even though not as much as in most other OECD countries and substantially less compared to housing price bubble period in 2005‑2007. There are discernible differences among the Baltic States with relatively more fragile situation in Estonia, where house prices (47%) grew faster than wages (20%), relatively sturdier situation in Latvia, where house prices (30%) were growing at similar pace to wages (28%), and Lithuania standing in between with fast growth of house prices (49%) and wages (38%). Low household indebtedness in the Baltics act as a mitigating factor, but high prevalence of floating‑rate mortgages increases housing market sensitivity to interest rate increases. Consequently, healthy housing price correction in the Baltics could not be excluded, which would reduce house price‑to‑income and housing price‑to‑rent ratios to more sustainable levels. 

Baltic tigers paused before the leap forward

The Baltic economies continue to demonstrate spectacular resilience to multiple adverse shocks: COVID‑19 pandemics, Russian invasion of Ukraine, energy and food price shocks, outstandingly high inflation and rising interest rates failed to disrupt Baltic economies on a larger scale. In 2022, economic growth slowed down. Growth remained in positive territory in Latvia (2.0%) and Lithuania (1.9%), but negative in Estonia (‑1.1%) as GDP was falling throughout the year following very strong economic performance in 2021 (8.0%). All three Baltic economies exceed pre‑pandemic heights reached in 2019 by a higher margin compared to EU average. We forecast that GDP growth in 2023 will remain weak (within the range of 0‑1%), but that requires strong growth throughout the year in Estonia from the level at end of 2022. Profound and broad‑based recession will be avoided. In 2024 the recovery will gather steam with GDP accelerating towards 3.5 – 4.0%. 

The sluggish overall performance hides vastly different performance of different sectors. High‑tech service sectors (IT, financial and business) are performing well with exports of IT and financial services in all three Baltic States rising by 30‑40% in 2022. The high‑tech service sector should continue performing relatively well in 2023 although rising interest rates may pose some challenges on fast growing start‑ups. Manufacturing sector, which, along with high‑tech service sector has been one of the main GDP growth engines, is facing increasingly strong headwinds from elevated energy prices, weakening foreign demand, deteriorating terms of trade as well as lasting supply chain disruptions caused by the Russian invasion of Ukraine. Manufacturing sector will continue acting as a drag on overall economic performance in 2023. Retail trade sector have been underperformer in 2022 as consumers were reluctant in increase spending in a face of higher inflation and increased uncertainty. Yet high employment, rising wages as well as falling energy prices improved consumer confidence recently, which suggest that the worst may be behind us. We do not expect private consumption to be a major drag on economic growth in 2023 in Latvia and Lithuania, but certainly high levels of consumption of early 2022 in Estonia are hard to keep up at the low purchasing power and rising interest rates. Housing market, nevertheless, is not out of the woods yet, since rising interest rates will continue dampening housing market recovery. We expect strong housing recovery to start in end‑2023 or 2024 – once interest rates will reach the peak and inflation rate will drop increasing purchasing power of households.      

The Baltic economic resilience is being supported by exceptionally high employment and low unemployment. Despite sluggish economic performance, employment increased by an impressive 5.1% in Lithuania, 4.6% in Estonia and 2.7% in Latvia – substantially faster than EU average of 2.0%. The increase was driven by increasing labor participation rate and successful integration of Ukrainian and Belarussian refugees into the labor market especially in Lithuania. Close to 50% of working‑age Ukrainian refugees have already found an employment in Lithuania, which is among the highest share in the EU. Unemployment rate continued to decline in 2022 and now stands close to record‑low levels in all three Baltic States. Tight labor market and high inflation supported strong wage growth, which for the fourth consecutive year remained even in double‑digit territory in Lithuania. High employment also kept consumer confidence, which, in turn, mitigated private consumption decline. It is forecasted that unemployment rate will increase only moderately in 2023 and labor market will remain comparably tight with wage growth being close to 10%.

The future economic development of Baltic economies will be affected by geopolitical tensions, the outcome of an ongoing Russian invasion of Ukraine as well as future developments of energy prices and the level of euro interest rates. Maintaining the functioning of the EU single market will also be of crucial importance, since small and open economies have lower capacity to compete with the biggest and richest European countries in subsidy race. Baltic economies should also invest heavily into renewable energy, which would not only increase energy security by reducing energy imports from the third countries, but also would ensure greener and more affordable energy for local businesses and consumers. This would allow Baltic region to gain competitive advantages in the longer term. Baltic States should also continue pursuing strategic economic reforms to improve its international competitiveness and resilience. The Baltic countries have virtually lost the status of low‑cost countries due to the rapid price convergence with the rest of the EU and wage growth during the last years. Hence, Baltic economies will need to compete with the Western European countries as with equals. To attract and retain investors and talents, it will no longer be enough to be as good as average European – the Baltics will need to become the best European.

Lithuania: Macroeconomy indicators (% annual changes unless otherwise noted)

Latvia: Macroeconomy indicators (% annual changes unless otherwise noted)

Estonia: Macroeconomy indicators (% annual changes unless otherwise noted)