Baltic economic overview 06/2024
Growth in the global economy remains robust despite numerous risks and geopolitical tensions.
Over the past two years, global GDP growth has exceeded 3%. However, this growth has been atypical, driven primarily by the recovery of service sectors from pandemic restrictions. For example, air travel in 2024 has finally reached 2019 levels. In contrast, manufacturing and world trade have experienced a moderate downturn since early 2022, but leading indicators suggest this downturn is coming to an end. The ongoing de-stocking cycle in manufacturing signals potential improvements in manufacturing, transport, and global trade. Additionally, declining inflation and gradual interest rate cuts provide a positive backdrop for a recovery in consumption in 2024. Nevertheless, the construction sector has become the economy's weakest link due to high interest rates affecting both residential and commercial real estate markets. According to the IMF's April 2024 World Economic Outlook, global GDP grew by 3.2% in 2023 and is expected to maintain this growth rate in 2024. However, this growth remains fragile, threatened by elevated geopolitical tensions, ongoing conflicts in Ukraine and the Middle East, high interest rates and debt levels, and the downturn in the Chinese property market among other risks.
Economic outlook in the euro area is improving.
Although growth in the euro area has been weak, signs of stabilization are increasing, and the growth outlook is improving after recession in 2023. Inflation in the euro area has declined, and the ECB began its rate-cutting cycle in June 2024. High interest rates have been constraining new lending and construction, but there are now indications that loan demand is starting to improve and share of companies reporting lack of orders is no longer increasing in Germany. Additionally, strong labour markets continue to support real income growth, leading to a significant improvement in consumer sentiment although saving intentions in Germany remain high as households continue to struggle with the impact from high inflation and prioritize improving their financial health. At the same time willingness of euro area consumers to spend on major goods is now higher than at the start of the ECB’s rate hiking cycle. Business surveys also point to ongoing de-stocking in the industry that should lead increase in new business orders. According to Bloomberg consensus forecasts, GDP growth in the euro area is expected to accelerate from 0.4% in 2023 to 0.7% in 2024. However, in recent months, natural gas prices in the euro area have increased by more than 30%. If this trend continues, it could derail the recovery in manufacturing and create new price pressures, potentially delaying interest rate cuts.
Growth in the US economy has exceeded expectations, but signs of weakness have emerged.
Growth in the US remains strong, with the consensus GDP growth forecast for 2024 now at 2.4%, according to Bloomberg consensus forecasts. In fact, growth forecasts for 2024 are now higher than at the start of 2022, before Russia's invasion of Ukraine, 9% inflation, and a 5.25% increase in interest rates. Business sentiment in the US remains positive, unemployment is low, and wages continue to grow. However, in recent months, some economic indicators have deteriorated. For example, small business hiring intentions have declined, loan delinquencies have increased, consumer credit delinquencies have surpassed 2019 levels, and new business orders in manufacturing fell sharply in May. These factors suggest a potential slowdown in the US economy in the second half of 2024.
Global inflation rates have declined and are now close to central bank targets.
The primary driver behind rapid decrease in inflation has been falling energy and commodity prices. However, in general other prices have not declined, domestic services inflation in advanced economies remains high, and some measures of inflation expectations are still well above previous levels. For example, in the euro area, despite mild economic recession in 2023, consumer prices excluding energy and unprocessed food have increased by 2% since the end of 2023. This rise is only slightly lower than price increases at the start of 2022 and 2023, and significantly higher than any year in the previous decade. Meanwhile, in the US, inflation has been stuck at around 3% since mid-2023, despite encouragingly low monthly inflation in May 2024. This indicates that underlying inflation pressures remain elevated. Strong labour markets have been a key factor driving domestic inflation, but in recent quarters, wage growth has finally slowed in both the US and the euro area to around 3% annually.
Energy and other commodity prices are no longer declining.
Since mid-2022 global commodity prices have fallen by almost 30%, however decline which helped reduce overall inflation rates, has stalled. Since February 2024 global commodity prices have increased by nearly 10% and the prices of copper, gold, aluminium, and some food commodities have risen by more than 10% since the beginning of the year. Additionally, in the euro area, natural gas prices have climbed in recent months and now exceed €35 per MWh. This rise in natural gas prices has been driven by both an improving outlook in the manufacturing sector and the war in Gaza, which has disrupted shipping in the Red Sea and significantly reduced LNG exports from the Middle East to Europe. Geopolitical risks have also increased global shipping costs. Rising commodity, transport, and energy prices mean that bringing inflation back to 2% could be challenging. The expected recovery in manufacturing and ongoing geopolitical tensions continue to support oil prices. However, OPEC countries currently have unusually large excess production capacity, allowing them to increase oil production if demand rebounds, which should help mitigate potential increases in oil prices.
The interest rate cutting cycle has begun, but rate cuts will be gradual.
Although inflation in the euro area and the U.S. has declined significantly, and the ECB took its first step in reducing interest rates by 0.25% in June 2024, inflation remains above central bank targets and has been more persistent than expected. As a result, financial markets have significantly revised down the number of expected interest rate cuts in 2024. At the start of the year, financial markets were expecting 6 or 7 rate cuts in 2024, but now rates in the U.S. are expected to be cut only once or twice. In its June meeting, the Fed also reduced its projected interest rate cuts in 2024 from three to one. The impact on lending from the first ECB interest rate cut will likely be limited. The ECB's rate cut was widely communicated in advance, expected by financial markets, and largely already priced into EURIBOR rates. For example, the six-month EURIBOR rate had already fallen from just over 3.9% in early March to 3.75% days before the ECB decision. Further declines in market rates will depend on future ECB decisions and ECB is expected to cut rates one or two more times in 2024. However, challenges related to inflation are far from over, and long-term interest rates remain well above levels seen in the previous decade. A return to very low or zero rates in the near term is highly unlikely.
Positive economic developments are supported by government borrowing and spending.
Despite high inflation, fiscal policies in many advanced economies remain very supportive, with governments continuing to borrow and run high fiscal deficits, leading to an increase in government debt. In the US, despite strong economic growth, the budget deficit is projected to exceed 6% of GDP in both 2024 and 2025—levels previously seen only during deep economic downturns or wars. This has already led to a rapid increase in interest rate expenditures. In the euro area, fiscal deficits are lower, and the longer duration of government debt has limited the negative impact of rising rates on government finances. Stimulative fiscal policy also partially offsets the impact of high interest rates. Current government priorities — higher military spending due to war in Ukraine, fight against climate change and green transition, increased protectionism and reshoring of manufacturing — favour more spending. Fiscal discipline currently is not a political priority, however negative reaction in the financial markets to recent election surprises in France underscore the risks posed by large fiscal deficits and high debt levels, and that market sentiment can shift abruptly.
Economic growth in the Baltics in the first quarter of 2024 was the strongest since early 2022.
In Q1 2024, Latvia's GDP increased by 0.1% compared to Q1 2023, and Lithuania's GDP grew by 2.9%, while Estonia's GDP fell by 2.4%. Although the overall economic outlook remains uncertain due to ongoing geopolitical tensions, high interest rates, and weak growth in the euro area, quarterly GDP in Q1 2024 grew by 0.9% in Latvia and 0.8% in Lithuania, but declined by 0.5% in Estonia. While growth in Latvia and Lithuania is still only moderate, this is the strongest quarterly growth in the Baltics since 2022. Estonia continues to lag behind Latvia and Lithuania due to higher interest rates, which have had a more significant impact on Estonia because of higher household and corporate debt levels. However, short-term leading business and consumer sentiment indicators in the Baltics continue to improve. This, along with the encouraging first-quarter GDP data, suggests that the recession in the Baltics has ended and moderate cyclical recovery will continue in 2024.
Inflation in the Baltics has declined rapidly since the start of 2023.
In May, inflation in Latvia and Lithuania fell to nearly 0%, while in Estonia it dropped to 2.9%. In Estonia, inflation in 2024 affected by an increase in the VAT rate. The decline in inflation is primarily driven by the base effects from lower energy prices. However, these lower energy prices have not translated into lower goods or services prices. Instead, domestic prices continue to grow, albeit at a slower pace, and domestic price pressures persist. Inflation expectations in the service sectors remain elevated relative to previous decade, with service price inflation still exceeding 5% in Latvia and Lithuania. In Latvia, service prices have increased by more than 3% since the start of 2024. While there is still potential for lower heating costs next winter, the overall inflation rate in the Baltics is likely to begin increasing in the coming months as the base effects of declining energy prices fade from the headline inflation data.
Despite weak economic growth, the labour market situation in the Baltic region remains positive.
Unemployment remains near historical lows, although it increased in the second half of 2023 and the first quarter of 2024 due to the economic slowdown, particularly in construction and manufacturing. Although the number of employed persons in the Baltics has decreased slightly, supply-side factors appear to be the main cause of the rise in unemployment. Positive net migration, including refugees from Ukraine, has increased labour force and more people, especially women, are now seeking work compared to a year ago. High inflation is likely the main reason for the increased participation of women in the labour market, as more families need a second wage to cover expenses. Additionally, the declining birth rate has led to a decrease in the number of women on parental leave and during the COVID-19 pandemic, many women dropped out of the labour force due to the additional burden of remote school or caring family members. These women are now returning to the labour market. Demographics continue to play a pivotal role as the working-age population in the Baltics shrinks. Low unemployment continues to put upward pressure on wages, and in Q1 2024, the average wage increased by 11% in Latvia, 10.3% in Lithuania, and 8.8% in Estonia. Strong wage growth without productivity gains can lead to loss of competitiveness, however in Latvia and Estonia wage growth has lagged inflation since 2021, and wages are only now catching up to inflation.
Manufacturing has been one of the worst-performing sectors over the past two years.
However, leading indicators suggest that the recession in the Baltic industry is ending, and growth prospects are beginning to improve. In April 2024, manufacturing output declined by 5.7% in Estonia and by 4.3% in Latvia compared to the previous year, while Lithuania's manufacturing sector grew by 2.9%. The main reason for optimism in manufacturing is the improving situation in the European manufacturing sector. Since December, economic sentiment in the industry has stabilized, and inventories of finished goods have started to decline. Stocks of goods in the industry grew rapidly after the pandemic, when restrictions on service industries were lifted, and large volumes unsold goods has been a significant drag on manufacturing over the past years as consumer demand has been hit by high inflation and rising interest rates. However, the situation is now changing, as evidenced by the increased volume of road freight transport in Germany since the beginning of the year, which is historically closely related to industrial activity in the European Union. Despite these positive trends, strong growth in manufacturing in the near term is unlikely. Most indicators currently point only to a moderate cyclical rebound driven by the de-stocking cycle although Baltic manufacturers could benefit from this rebound more than other countries as manufacturers from Western Europe tend to shift production towards lower cost countries when demand is weak.
Stagnation in retail trade is probably coming to an end.
Wages in the Baltics continue to grow rapidly, unemployment is generally low, and inflation is currently below 1% in Latvia and Lithuania, and below 3% in Estonia. Consumer sentiment in the Baltics is improving, with the assessment of their financial situation over the next 12 months reaching a multi-year high in Lithuania, and retail trade in Lithuania has been growing since the end of 2023. Retail sales and consumer confidence in Estonia have lagged behind Lithuania and Latvia. Due to higher levels of household debt, Estonian consumers have been more affected by high interest rates, and somewhat weaker wage growth in Estonia has not kept up with inflation. In Latvia, wages have increased by 33% since the beginning of 2021, while prices have grown by 35%, so there has been no basis for a significant increase in consumption, and households have prioritized improving their financial position. Only in Lithuania has wage growth exceeded price growth over the past three years, contributing to growing retail sales. The overall outlook for the retail sector remains positive, as wages in the Baltics continue to grow rapidly, inflation is low, household deposits in banks are increasing again, and interest rates are expected to gradually decrease this year.
Construction is expected to decline in 2024 and remains the weakest link in the economy.
In Q1 2024, construction volume in Estonia declined by 12.6% compared to the previous year, and by 5.7% in Latvia. In contrast, construction in Lithuania increased by 7.7% as construction of infrastructure objects surged by more than 25%. In the private sector, high interest rates have dampened real estate market activity as potential buyers await interest rate reductions. Due to subdued demand, unsold inventory has accumulated in new residential developments, prompting developers to postpone new projects or focus on smaller-scale developments. Despite this, real estate prices have not decreased, and with interest rates beginning to decline slightly in recent months, new mortgage lending has increased again since the start of 2024. Offsetting weakness in the private sector is strong demand in the public sector, driven by EU-financed and energy-related investments.
Banking sector in the Baltic region is well placed to increase lending and support economic growth.
Following interest rate hikes by the ECB and other central banks to curb inflation, bank profitability in the Baltic region has increased as interest rates on loans rose faster than bank financing costs resulting in a significant increase in net interest margins. At the same time, high interest rates, inflation, and economic recession negatively impacted consumers and businesses, leading to a slowdown in deposit and loan growth throughout 2023. Despite these challenges, now there are sings that economic situation has begun to improve. Deposit growth is now rebounding in Latvia and Lithuania, supported by declining inflation, as households prioritize improving their financial stability. And despite still high interest rates, new lending remains robust, supported by growing confidence among households and businesses that interest rates have likely peaked. Nonetheless, lending in Latvia continues to lag behind Lithuania and Estonia, largely due to lower levels of mortgage lending and financing in the real estate and construction sectors.
Situation in the global economy remains uncertain, however economic growth in the Baltics is expected to improve in 2024 and 2025.
Despite various risks, world economy continues to grow while in euro area business sentiment has recently improved. In Latvia and Lithuania, declining inflation has led to improving consumer confidence and in the second quarter of 2024, new industrial orders rose significantly across all Baltic countries. A rebound in global manufacturing, driven by a destocking cycle, is anticipated to benefit the manufacturing and logistics sectors in the Baltics. At the same time strong labour markets, rising wages, and low inflation are expected to support growth retail trade and domestic services. However, in the construction sector, the outlook is mixed. Government investment is increasing in Latvia, Lithuania, and Estonia, supported by EU financing and energy sector projects. However, the private sector remains cautious due to high interest rates and this may lead to a decline in construction output in 2024. Inflation in the Baltics is expected to remain low in 2024 but will start to increase towards the year's end as the base effects from lower energy prices diminish. Domestic inflation is likely to remain persistent due to robust wage growth, low unemployment, and elevated inflation expectations, especially in the service sector. In 2025, inflation is expected to accelerate to over 2%. Wage growth continues to outpace productivity, but is projected to moderate in 2025, constrained by declining GDP and inflation in the private sector. At the same time wages in public sector are expected to grow faster than those in the private sector due to significant increases in public sector expenditure.
However, significant risks persist.
While leading economic indicators show improvement in Europe, the US economy has shown some signs of weakness, and China continues to struggle with downturn in its real estate sector. However, the most significant risks are currently related to the geopolitical situation in the world and in the region. The war started by Russia against Ukraine continues, conflicts in the Middle East have disrupted global trade, and tensions between the USA and China continue to worsen. So far, the impact of these geopolitical factors on the Baltics has been relatively limited. However, the impact from the war is one of the factors that contributed to a credit rating downgrade for the entire Baltic region by the S&P credit rating agency. Additionally, inflation in developed countries is not declining as fast as expected, suggesting that interest rates may remain higher for longer. And despite positive economic growth, many countries continue to run significant budget deficits and debt levels are high. Given current high interest rate environment, fiscal policies of some countries could become unsustainable without substantial reductions in budget deficits in the coming years.
More detailed analysis: Graphs and charts (English)