Spring 2021: Global economic outlook

Global recession caused by the COVID‑19 black swan. The unexpected emergence of the coronavirus pandemic and the global trade tensions were overwhelmingly the two dominant macro narratives in 2020, causing an unprecedented global recession which spanned both developed and developing countries alike.

Growth contracted in the key export markets for the Baltics in H1 2020, including the euro area and the Nordic countries, with large parts of the economy severely hit with COVID‑19 related spring lockdowns in Europe.

The Baltic open economies were severely affected by COVID‑19 crisis as coronavirus restrictions led to both a halt of cross‑border trade and strained large parts of the business activity (in particular, in the services industry) due to the rather broad lockdowns implemented aiming for social distancing. Moreover, at the height of the crisis there were not just disruptions to global value chains, but initially even impediments to the movement of goods within the single market. This exaggerated the downturn in the economically highly integrated and open economies of Estonia, Latvia and Lithuania.

Yet the growth in Baltic countries was markedly less impacted last year by the pandemic than many other parts of euro area, which is related among other factors to the more limited spread of the coronavirus, successful medical response and the flexibility of the corporate sector to work out swiftly solutions to keep the vital parts of the business open. Furthermore, the labor markets and business sector benefited from the fiscal support (including job‑retention scheme), which high‑lighted the importance of demand management to smooth the negative effects from global crisis. As members of the Euro area the Baltic economies were standing on an equal footing with other euro area partners and could offer this time around comparable fiscal support to their economies, which was not the case back during the 2008 global crisis. During the financial crisis discretionary support by Baltic countries was limited not least by shallow local currency debt markets. In addition, Estonia had to meet the Maastricht criteria limiting the deficit to 3 percent of GDP at a time.

Given the structural changes of the past decade the Baltic economies have become considerably more resilient yet dynamic economies. It is a remarkable achievement, that at the very height of COVID‑19 lockdowns, in the second quarter of 2020, real GDP contracted by 5.4% over the year in Estonia, 8.6% in Latvia and 4.7% in Lithuania, as compared to the average fall of 14.7% in the euro area.

The Baltic economies staged a decent rebound in Q3 2020 along with other euro‑area peers while lifting of COVID‑19 restrictions. Namely, the GDP in Estonia and Latvia were off just 3.5% and 2.8% respectively from a year before and 0.1% above precrisis level in Lithuania in Q3, which is comparable to other Nordic economies. At the end of the year the GDP levels where not far from pre‑crisis level. The recovery has been led by the consumer, but also exports and investments staged a noticeable comeback.

Despite the economic uncertainty and reduced tourist flows, the volume of retail trade exceeded its level of the previous year as early as May in Estonia and Lithuania, with Latvia exceeding its pre‑crisis level in June. Retail trade has continued strong into the year‑end reflecting resilience of the consumer. Recovery in demand has been supported by stronger balance sheets ahead of the pandemic with accumulated savings and modest consumer leverage. Retail trade staged a vigilant comeback despite the paycheck support programs and social transfers being on average rather modest in terms of duration and size (some euro area members have furlough support programs continuing into spring). As a supporting structural factor there were no external imbalances to correct during the current pandemic as the Baltic states have run substantial external surpluses and close to balance budget positions in the past decade. Moreover, the well capitalized banking sector befitting from central banks’ bold support enabled refinancing during the critical spring lockdown period, with new lending growth expected to continue at good pace in 2021.

The recovery going forward will remain still uneven and subdued in the near term with the new resurgence of the virus with more infectious strain expected to dampen retail and other parts of the services sector most affected by new targeted distancing measures. For example, the purchase of durables (such as new passenger cars) continues to lag in the current cyclical recovery of the economy.

New passenger car sales in euro area suffered their biggest ever drop of 24.2% in 2020 (including ‑29.5% in Estonia, ‑25.8% in Latvia and less ‑12.9% in Lithuania). Registrations picked up in the Baltic countries towards the end of the year along with a positive structural shift towards a higher share of climate friendly hybrid and electric cars being sold. However, the new dose of distancing measures introduced to tame the second coronavirus wave are likely to weigh on car sales in the Baltic countries in Q1, before the recovery can set in as we approach the summer season. The low base from last year plus the slower rate of new infections (already evident in some larger euro area countries in Q1) will likely lift sales as we approach the summer.

There is still considerable uncertainty about the future evolvement of the pandemic despite the rising vaccinations rate in the EU, which has lagged some of the other advanced countries including the US and UK. The supply of vaccines will pick up in Q2 allowing an increasing number of euro area members to gradually lift their coronavirus restrictions over the summer.

The expected re‑opening of economies will not only allow to release some of the pent‑up demand (excess savings), but will lead to selective shifts in consumption patterns. Such as the share of services in consumer basket will expand relative to selective goods categories. For example, dining outside and restaurant meals will regain momentum relative to purchases of meals at home, as the catering sector re‑opens and the return to office trend gains finally gradually traction.

There are also early announcements of some airlines anticipating a pick‑up of tourism traffic (starting from domestic flights) as early as H2, with pre‑crisis volumes (on a sustainable basis) in their assessment still some two years away. The pickup in vaccination rates, fast testing capability and potentially delivery of vaccination passports can offer some confidence that better years are ahead even for the sectors, which experience a more subdued recovery.

As a positive Europe’s largest economy, Germany has announced early March a plan to gradually unwind coronavirus restrictions as infection rates hold stable and increased testing provides a “buffer” to allow easing sooner. Increased use of rapid tests, self‑testing kits, and acceleration of the immunization programs, by using the maximum time allotted between first and second measures, are examples of the measures facilitating the road towards future re‑openings of economies besides progress in vaccinations. There are good reasons for economic momentum to pick‑up in H2 with Baltics experiencing above‑trend GDP growth already next year accompanied by reflation and tightening in labour markets. Youth unemployment is another reminiscence of the uneven recovery with COVID‑19.

Estonia’s COVID‑19 experience demonstrated resilience of the economy, which can be partly attributed to the stronger economic fundamentals ahead of the pandemic (including consistent current account surpluses). After the 5% real GDP boost in 2019, the Estonian economy dived at the height of the pandemic into an annual decline of ‑5.5% in Q2 that was more moderate than expected. Whilst the decline in investments and export contracted sharply as expected, private consumption proved to be much more resilient. The rather swift recovery of the Estonian economy to ‑1.8% y/y in Q4 GDP has been driven by a much more resilient consumer and a substantial boost to corporate investments. The volume of retail trade exceeded the level of last year in Estonia already in May with average 3.5% y/y volume growth for 2020 (‑1.1% y/y in Euro area).

The economy has undergone nevertheless a significant disruption with a rather long road ahead until the full broad‑based recovery is reached. After the sharp contraction of export dependent industries in Q2 the sector is now set on a gradual recovery path with goods exports delivering 14.4% y/y growth in Q4 (2% y/y for 2020), while services exports continue to suffer from constrained tourism and transport flows. Moreover, the industrial production volumes have recovered to a pre‑crisis level following the global manufacturing upcycle. As a positive future development energy sector is expected to contribute to growth in H1 2021 due to the cold weather and rising energy prices in the Nordic region. Energy sector will be one of the key attractive growth areas looking for new green investments with the support from EU structural funds. The share of renewables in Estonia’s energy consumption exceeded the 20 percent threshold already in 2009 and extended beyond a 30 percent mark in 2019.

Overall, Estonia has maintained a strong position among the resilient and fastest growing euro‑area economies with an annual average 3.1% y/y GDP growth (0.6% y/y in Euro area) during the last decade (2010‑20). The future will include more structural changes ahead with the Green transformation adding to the already strong leap undertaken in the digitalization area, which has helped to keep the economy open during the pandemic. Investments exceeded pre‑crisis level by 18% last year. Expect significant investments in offshore wind, the grid and electrification to pick up considerable with Estonia ambitions for climate neutral economy in 2050. Looking forward the well‑established ICT sector, which continued to expand throughout the pandemic will likely act as a facilitator to unlock the innovation potential across other sectors in the economy. There is a great potential to attract new FDI investments. For example, German automaker Volkswagen founded software company Car.Software Estonia AS last year with plans for long‑term investment. The start‑up ecosystem remains an active springboard for companies with a focus on the global consumer.

The Estonian recovery remains still very much incomplete and uneven with the second wave of the COVID‑19 leaving the near‑term activity subdued and unemployment elevated. The short‑term dampening effect on the economic activity from the COVID‑19 second wave is however less constrained due to targeted distancing restrictions and the behavioral adjustments as the economic agents are learning to live with the virus. The economy is set to gain momentum from the second half of 2021, as the key drivers for recovery are linked to the improvement in foreign demand, which will benefit not least from the accelerating speed of vaccinations in the EU and the forthcoming fiscal support. Growth will reach 2.5 percent in 2021 and reach 5 percent next year with accompanying inflationary pressures and labor market recovery. What remains crucial for Estonia is to devise a roadmap towards climate neutral and low carbon economy. The green investments will offer plenty of revenue growth potential ahead. For the benefit of wider society those long‑term investments must be now planned with extra care to benefit the environment and tourism, as also green offshore windmills can have negative externalities including for the surrounding nature and tourism. Sound planning and responsible investment will yield long‑term benefits ensuring Estonia will maximize the opportunities from the greatest asset of all, which is the rich nature.

Latvian economy performed even better than in our optimistic scenario in the spring Economic Outlook with GDP contracting by 3.6% in 2020. The main success factors were exemplary virus containment until November, achieved with light‑touch restrictions on economic activity, combined with very satisfying results in parts of manufacturing and white‑collar services.

The relative growth underperformance vs. Estonia and Lithuania was caused by the sharp fall of consumption (‑10%) vs ca 2% decline in other Baltics. That is a bit perplexing as retail performance that was on par with Baltic peers. Cautious fiscal policy especially comparing to Lithuania could be part of the explanation. Overall, export performance is similar across Baltics. Latvian manufacturing was slightly more resilient than that of neighboring countries, but it suffered more in services as the country was affected not just by pandemic impact of tourism, but also by sustained decline of East‑West cargo transit. Manufacturing was supported by the large share of country’s well‑performing timber industry (+4.1% in 2020) that was boosted from housing investment in export markets that also benefited chemicals (+3.0%). Engineering sectors (metal processing, machinery, electronics) performed well in given circumstances, boosted by successful product portfolio, for example, specialization of electronics industry in telecoms equipment. Like across the region, high value‑added service exports continued to boom.

We are cautious about Latvia’s prospects for 2021. Due to absurd (non)decisions about vaccine procurement in late 2020 immunization is proceeding slowly. Increasing disregard for safety rules is keeping virus spread at an elevated level, preventing the easing of restrictions on retail and other service sectors. Annual decline of output in Q1 could be of similar magnitude to the one in Q2, 2020. Strong q/q growth in the following quarters is expected, but due to the low starting point the GDP growth is likely to be just 2.1%. Growth rate across Baltics will be below European average due the mildness of recession in 2020 thus more limited cyclical rebound space.

On the other hand, we are very enthusiastic about prospects for 2022 and the following years. The medium‑term future is very bright. Economy will be turbocharged by extremely favourable conditions across the landscape – consumption, investment, exports. Consumption suppressed by pandemic restrictions will bounce back without any policy effort. Over 10 billion investment boost from “regular” EU funds (2021‑2027 financial framework), Recovery and Resilience Facility and RailBaltica will start to flood in. Plus, conditions in export markets are set to be favourable. So we predict that Latvia’s GDP growth in 2022 will reach 7%.

Growth spurt in 2022 is inevitable in the absence of major new global risks. The most interesting question is – will this episode spark self‑sustaining boom? There is at least a chance for that. Latvian exports went through purgatory since 2014, an unfortunate chain of events (Russia sanctions, end of non‑resident banking business, transit crisis) caused pain, but also lead to healthier structure that favors faster expansion. Latvian household mortgage debt is the lowest in euro area, unlike in other Baltics, the housing market has slumbered and there is a potential for upswing. External funds for investment will flood in. Local governance has improved substantially in cities accounting for ~2/3 of Latvia’s economy. There will still be problems in near future, but most likely ones related to fast growth and structural change – labour market overheating, infrastructure bottlenecks, probably also some excesses in the housing market.

Lithuanian economy has demonstrated spectacular resilience to the COVID‑19 crisis with GDP declining by a mere 0.8% in 2020 – the lowest drop in the Baltics and the second lowest in the EU. After the brief lockdown in spring, Lithuanian economy bounced back in summer with both domestic consumption and exports reaching pre‑crisis levels already in 2020 Q3. Economic recovery was reminiscent to the “V‑shaped” pattern, i.e. a sharp but short drop followed by robust and broad‑based recovery. Growth was further boosted by an impressive growth of ICT and financial services exports, driven by rapid expansion of ICT sector in Kaunas and positioning of Vilnius as one of the largest FinTech centers in the EU. Real estate sector has also demonstrated spectacular resilience with prices continuing to grow and the number of residential real estate transactions falling by less than one percent in 2020. Good harvest also gave a temporary boost to agriculture sector further limiting overall GDP drop, while comparably lower share of travel and other leisure service activities made overall GDP drop less pronounced in Lithuania, compared to other Baltic States. Domestic consumption and housing sector was supported by a record‑high influx of returning migrants from Western Europe and the United Kingdom in particular.

Re‑emergence of COVID‑19 restrictions have slowed down economic recovery in end‑2020 and the beginning of 2021. However, despite longer and stricter lockdown, overall economic impact will be limited, since manufacturing, transport, agriculture, real estate and ICT services sectors are experiencing no, or only minor and temporary drop in activity, while sectors that are most affected (hospitality and leisure services) constitute relatively small share in Lithuanian economy and does not have substantial effect on overall GDP figures. However, the most affected sectors should not be disregarded, because they employ quite substantial amount of people (especially youth) and are dominated by smaller and medium‑sized enterprises, which generally are more vulnerable financially and are more prone to carry out activities illegally. Hence, prolonged lockdown restrictions risk increasing emigration (especially of younger people) and shadow economy, which may have long‑term effect on growth potential. Another challenge is that economic recovery is increasingly reminiscent to the “K‑shaped” pattern with diverging fortunes between different economic sectors, social classes and company characteristics, which may have longer‑term effects on market efficiency, competition environment and employment possibilities. Contrary to spring lockdown, there is no more shared feeling that everyone is sitting in the same boat. Finally, there is an increasing risk of excessive public debt growth. Lithuanian government deficit was among the largest in the region in 2020 due to excessive spending during the pre‑election campaign. In 2021 it will likely be the largest again due to relatively stricter and longer lockdown.

The path to economic recovery in 2021 will largely depend on how fast lockdown restrictions will be eased in Lithuania and other EU countries and whether pandemic‑related uncertainty will persist well beyond spring. Lithuanian economy is expected to dip back into recession in 2020 Q1 – the magnitude of which will be reminiscent to 2020 Q2. However, economic recovery might be somewhat slower in 2021 Q2, since at least some lockdown restrictions will likely be retained in Lithuania and other EU countries. As a result, economic recovery is expected to accelerate only in 2021 Q3, hence, contrary to 2020, this time economic recovery will be more reminiscent to “U”‑shaped, rather than “V”‑shaped pattern. As a result, overall economic growth for 2021 is forecasted to be below 2%, which would be among the lowest in the EU.
In 2022 economic growth should accelerate towards 5‑6%, but the level of GDP would still be around 4 p.p. below the potential. The growth in 2022 to a large extent will depend on the recovery of the European Union, the usage of Economic recovery fund money, private investment dynamics and whether shadow economy and emigration risks will materialize. There is also an increasing risk that in 2022 discussions about fiscal consolidation will start, which, if made prematurely, could derail economic rebound. On the other hand of the spectrum, risks related to housing market and labour market overheating may increase macroeconomic imbalances going forward.

Overall, there is broad‑based recovery ahead for Estonia, Latvia, and Lithuania from H2 as the COVID‑19 second wave related better targeted and more measured restrictions will be gradually phased out. The recent intensification of containment measures in response to a notable resurgence of coronavirus infections is expected to remain the activity subdued ahead of the approaching spring season, not least given the strong recovery already seen last year. However, the setbacks from the second wave to the Baltic and other euro‑area economies have been far more limited and nothing comparable to the experience from last spring with full lockdowns, significant global trade contraction and few visibilities in terms of vaccinations.

There is plenty of pent‑up demand to be unleashed in the Baltic countries with savings growth continuing strong. Despite the near‑term setback from the coronavirus resurgence and the slow start to vaccinations, the news on accelerating vaccines supply and increasing vaccinations of the most vulnerable population give greater confidence in the assumption of a gradual resolution of the health crisis throughout 2021 and in early 2022. The better prospects for global economy with expected re‑opening of economies coupled with stimulatory monetary and fiscal policy is already lifting market expectations for inflation and longer‑term rates. The recovery in euro area, including the Baltic export dependent economies is on its way.

COVID‑19 related stimulus lends a historic opportunity to speed up Green and digital transformation based on building alliances between the states and private sector. The unprecedented stress from the pandemic and extreme climate events of the past years have presented a renowned opportunity to mobilize enough support behind the transformative global green agenda. Namely, last year marked the sea‑change in terms of bold policy commitments with an increasing number of countries announcing their climate‑neutral targets (including the EU, Japan, Canada, South Korea targeting carbon neutrality by 2050 and China aiming for 2060), with the U.S. rejoining the Paris Climate Agreement. This is the best side‑effects of coronavirus benefiting the world long‑term.

No doubt the challenges and opportunities from green transformation will be multifaceted not least for the small Baltic countries, which have less resources compared to larger euro area peers to make the ambiguous investments into the innovative technologies underpinning the green transition. The challenge of the coronavirus pandemic added urgency to address long‑standing endeavors to better use research and innovation to tackle health emergencies, climate change and digital transformation all at the same time. One of the renowned strong advocates for climate change, Bill Gates has reflected: “Green products is going to require huge investment by governments in research and development as well as support to allow the market for new products and technologies to grow, thereby helping drive down prices.” EU has embarked on an ambitious green agenda, which will be transformative for the economies.

The Baltic countries have started to devise investment plans for a transition into a more green, circular, and digital economies, which are required to reach the ambiguous 2050 climate neutral ambitions. The Baltic countries are well positioned to match the green ambitions with the start of the new EU structural funds program running from 2021 to 2027. We are today at the initial stages of research what green technologies will provide the ultimate cost‑efficient solutions to replace large parts of the fossil‑fuels run economies with limited circulation of resources. On its way to the more climate friendly economies the definition of climate neutrality and related standards are likely to change as we learn more about the new enabling technologies coming to the market. Transparency and a drive towards more harmonized standards will be crucial ingredients for establishing the more level‑playing field between the providers of green products and services.

The strength of EU is evident in not only facilitating agreement on a common path to climate neutrality across many countries, but also in emergence of across the country’s partnerships, like we have seen in a transition to electric self‑driving cars, which will be critical for converging towards more common standards and best practices to achieve a durable and efficient solutions for climate change. It remains to be seen how successful the modern technologies will be to drive down the initial short‑term green premium, which the consumers must face from the green transition. However, the long‑term gains for the quality of life of citizens (being the cleans air of cities, biodiversity, and protection of environment to be enjoyed also by next generations) and employment opportunities from the ambitious global green investments will by far outweigh any short‑term extra costs, which might be incurred and financed with funding conditions remaining as favorable as today. One could compare today’s climate challenges related to the rebuilding of Europe after WWII, with green transformations offering common goals and long‑term benefits to be shared on a global scale. COVID‑19 has offered us tremendous opportunity we will learn next decades.