18.09.2024.
The Baltic economies have demonstrated resilience to a multitude of negative external shocks. Increased geopolitical uncertainties, energy price shocks, interest rate hikes, regional trade disruptions and EU economic stagnation temporarily slowed down, but did not knock down small open Baltic economies. Lithuania proved to be the most resilient with GDP forecasted to expand by 2.4% in 2024, followed by Latvia (0.3%) and still fighting with recession Estonia (-1.0%). All three Baltic economies are forecasted to return to a growth path in 2025 albeit differences among the countries will remain. Lithuanian economy is projected to lead the recovery by growing at 3.0%, followed by Latvia (1.8%) and Estonia (1%). Private consumption will be the key economic growth driver as households in Latvia and Lithuania will benefit from robust wage growth, low inflation. Estonia is more likely to benefit more from increasing foreign demand. Falling interest rates will help everybody in the Baltics. Weak external demand is hindering manufacturing sector , but IT and other high-tech sectors will have higher potential. Investments will continue to be supported by ample EU funds as well as investments into renewable energy and defense sector. Given that Baltic countries can no longer be perceived as a lower price and lower labour cost region, its longer-term economic growth prospects will largely depend on the investments into high-tech manufacturing and service sectors.
All three Baltic economies used to grow at a similar pace, but during the last five-year period growth trajectories have markedly diverged. Consequently, Lithuanian economy is now 11% higher compared to 2019 levels, Latvian – 6% higher, whereas Estonian economy, which is approaching the end of 8-quarter long recession, has dropped back to 2019 levels (the EU average is 5% higher). The difference between the growth trajectories is explained both by structural and cyclical factors.
The Lithuanian economy has been strongly supported by manufacturing sector, whereas Estonian, and to some extent – Latvian, manufacturing sector continues to act as a drag. Lithuanian manufacturing sector expanded fast in 2020-2021 due to its high flexibility and lower dependence on disrupted global supply chains, whereas diversified export geography allowed it to maintain production at high levels in 2023-2024. Estonian manufacturing, on the other hand, continue to suffer from its high dependence on stagnating Finnish and Swedish construction and real estate sectors (Finnish economy is only now getting out of a recession), whereas Latvian manufacturing sector is relatively more exposed to cyclical wood and furniture sector, which suffers from an ongoing housing market downturn. Lithuanian manufacturing production volumes are ~28% higher compared to 2019 levels (the third-highest growth in the EU behind Ireland and Denmark), whereas in Estonia they are ~9% lower (the third-highest drop after Germany and Luxembourg) while in Latvia roughly at 2019 levels. Lithuanian manufacturing development is thus reminiscent to the Polish one, whereas Latvian and Estonian – to the Finnish one. Lithuanian manufacturing sector have relatively higher structural, whereas Estonian – higher cyclical growth potential as it is evidenced by the differences in capacity utilization rate (65% in Estonia vs. 72% in Lithuania and Latvia). However, leading indicators suggest that the manufacturing sector recovery will be only gradual.
The Lithuanian economy has also been boosted by exceptionally strong growth of high-tech service exports supported by buoyant fintech sector, rising unicorns as well as relocation of Belarussian IT companies. High-tech service exports (IT, financial and other business) over the last 4 years (2023 compared to 2019) increased by 222% in Lithuania, 161% in Estonia and 66% in Latvia (growth is Latvia was slowed down by shrinking financial service exports to CIS countries). Prior to 2019 Lithuania was lagging behind Estonia and Latvia, but in 2023 it became the largest exporter of high-tech service exports in the Baltics (on per-capita basis, Estonia is still leading by a wide margin). The latest data indicate that high-tech service sectors grow less than before in Estonia, continue to grow at decent pace in Latvia and the growth is the strongest in Lithuania. The latter also has an advantage in that in Latvia and Estonia high-tech service sector activities are largely concentrated in capital cities – Riga and Tallinn – whereas in Lithuania it is active not only in capital city Vilnius, but also in the second-largest city Kaunas. Estonia, famous for its start-up ecosystem, is also struggling from higher interest rates, which reduced the flow of risk capital into start-up companies. Yet, dropping interest rates may reinvigorate this segment, hence Estonia has somewhat higher cyclical recovery potential. Latvia, on the other hand, also has potential, since after years of stagnation it is growing its modern office stock at the fastest rate in the Baltics.
The difference between Baltic States is also evidenced looking at consumer confidence indicators with Lithuanian consumers remaining more confident compared to Latvian and Estonian counterparts. Consumer confidence indicator in Lithuania has been consistently amongst the highest in the EU, whereas in Estonia it recently dropped to the second lowest in the EU and Latvian has risen above the EU average. Consumer confidence tightly correlates with household consumption dynamics. For example, retail trade volumes in 2024 January-July were 3.4% higher in Lithuania, 0.1% higher in Latvia and -4.1% lower in Estonia compared to the same period last year. The recent consumer confidence indicators suggest that household consumption trajectories will continue to diverge.
Differing fiscal policies exacerbate an ongoing divergence between the Baltic States. Estonia is implementing a broad-based fiscal consolidation by raising VAT, personal income and dividend taxes. Specifically, Estonia has increased VAT from 20% to 22% in January 2024 and is planning to increase it further to 24% from July 2025. Estonia is increasing personal income and dividend tax from 20% to 22% for 2025 and planning to increase them up to 24% in 2026. A car tax is introduced and a potential new tax on corporate profits is also being discussed. The aim of the tax increases is to fill the widening gap between budget revenues and expenditures as well as to allocate more funds for defense spending. Latvia and Lithuania are reluctant to follow the Estonian fiscal consolidation path and instead carries out relatively minor adjustments to existing tax systems e.g. Lithuania in 2025 plan to increase excise taxes, rise profit tax by 1 p.p. (from 15% to 16%) and extend the validity of the bank solidarity tax. Latvia and Lithuania feel less pressure to implement broad-based fiscal consolidation, given their lower budget deficits: budget deficit to GDP ratio in 2023 was 3.5% in Estonia, 2.2% in Latvia and a mere 0.8% in Lithuania. It is forecasted that in 2024 budget deficit in Estonia will remain higher (3% of GDP) compared to Latvia (2.8% of GDP) and Lithuania (1.6% of GDP), hence Latvia, and especially Lithuania, is unlikely to follow Estonia’s fiscal consolidation policy path in the near future. It should also be noted that tax to GDP ratio is at record-high levels both in Lithuania and Latvia thanks to stronger tax compliance, shrinking shadow economy and rapidly growing wages (social security and income taxes are the main budget revenue source), which further limits the need to increase tax rates.
Differences in fiscal policies, in turn, will support an ongoing economic divergence among the Baltic States, especially given that Finland, which is Estonia’s main trading partner, is also implementing fiscal consolidation measures (e.g. Finland increased VAT in September 2024 from 24% to 25.5% and is cutting expenditures). We forecast that fiscal consolidation measures will amplify Estonian inflation and depress its GDP growth in 2025 and 2026 relative to Latvia and Lithuania. Yet, the possibility that Latvia and Lithuania may follow Estonia’s fiscal consolidation path in a more distant future cannot be excluded – especially given mounting pressures to rise social, health and defense spending. In Lithuania certain fiscal consolidation measures can be implemented in 2025 by the newly formed government following Parliamentary elections in end-2024, but the scope and timing of these measures remain uncertain. Hence, under the baseline scenario we assume that Lithuania and Latvia will not implement any additional fiscal consolidation measures in 2025 and 2026, although it remains a downside risk for our forecasts.
Inflation in the Baltics, as we have forecasted, has dropped substantially from being among the highest to being among the lowest in the euro area for Latvia and Lithuania. In 2022 the top three countries with the highest inflation in the euro area were Estonia (19.4%), Lithuania (18.9%) and Latvia (17.2%). In 2024 it is forecasted that Lithuania (0.8%) and Latvia (1.2%) will be among the top three euro area countries with the lowest inflation. Estonia, however, will have higher inflation (4.0%) primarily caused by a hike of VAT tax (from 20% to 22%) in the beginning of the year, which gave a one-off boost to inflation. We are forecasting that inflation will remain low in Latvia and Lithuania in 2024 and 2025, given that energy and food prices, which were the main inflationary drivers in the past, are expected to remain stable or gradually decline. Inflation in the Latvian and Lithuanian inflation should remain close to euro area average of 2% both in 2025 and 2026, with inflation in Estonia higher, reaching 5% in 2025 due to increasing excise duties, car taxes, personal income tax and planned increase in VAT in 2025. Service inflation will continue to be elevated driven by wage growth, but it will have somewhat limited impact on overall inflation, since services constitute a relatively lower share of the consumer basket in the Baltic countries (27-32%) compared to euro area average (45%). The rapid price growth in the Baltics was partly driven by an ongoing price convergence with the rest of the EU, but further convergence potential became limited, as price levels in many categories already caught up to the EU average levels. For example, the price level of food and non-alcoholic beverages already exceed the EU average in all Baltic countries, with Estonian price level only 1% lower than in neighboring Finland. Latvia and Lithuania so far do not have plans to increase VAT, but are increasing excise taxes, which will also result in somewhat higher inflation. In the future, administrative decisions will make an increasingly important role on inflation developments.
Labor markets in all three Baltic states remain surprisingly active despite subdued economic growth: wages are rising, unemployment rates stay low, while job vacancies remain ample. Yet, we forecast that labour market will cool down in 2025 before gradually recovering in 2026. Wage growth should slow down, but unemployment will remain relatively low as companies are reluctant to lay off workers fearful of broad-based scarcity of employees. Employees will no longer be kings of the labour market, but neither will employers, hence we forecast more balanced Baltic labour markets going forward.
The wage growth in all three Baltic States was in double-digit territory in 2022-2023 but is forecasted to moderate towards 6-8%. The exceptionally fast wage growth in 2022-2023 was primarily driven by high inflation, which allowed companies to pass through increased labor costs to consumers. With inflation dropping, the capacity of Baltic companies to increase wages further has been substantially curtailed. Wages have also been consistently growing faster than productivity during the last decade. As a result, the wage to GDP ratio in all three Baltic States now exceeds the EU average, which further limits wage growth potential. Wage growth in the private sector has already moderated to single-digit levels, but overall wage growth numbers are being somewhat inflated by still rapidly growing public sector wages in Latvia and Lithuania.
The unemployment rate is gradually rising, but remains at relatively low levels. An increase in unemployment is primarily a result of an inclusion of an increasing number of Ukrainian war refugees into the statistics rather than a drop in the number of employed. We do not expect unemployment to increase substantially, since Baltic businesses are reluctant to lay off workers fearful of fundamental labor shortages. Unfavorable demographic situation will compel Baltic companies to increasingly rely on immigration to fill employment gaps. As a result, smart and inclusive immigration policy will become the key policy priority as it will largely determine longer-term economic growth prospects of Baltic states. Investments into robotization, automatization and artificial intelligence will also play an increasingly important role in productivity growth. At the same time, pressure on labour-intensive industries (e.g. textiles) will continue, which will support relocation to lower-wage countries.
The housing market in all three Baltic states have demonstrated surprising resilience. Contrary to many other EU countries, an outright housing price correction has not taken place. The recent indicators suggest that the housing markets in Latvia and Lithuania have already turned or is about to turn the corner and the activity will gradually be picking up albeit from the low levels. The prospect of lower interest rates is already increasing housing loan demand and the number of transactions since mid-2024 with newly issued housing loan volumes notably increased and reached record-high levels in July 2024 both in Latvia and Lithuania. Estonian market remains cool as market turnover is not increasing and prices indexes have shown stability. The credit market activity also picking up in Estonia although some of the growth is coming from the refinancing of existing mortgages. It is expected that housing market activity will continue to gradually increase encouraged by rising wages and falling interest rates. The housing affordability is gradually improving, but it is still worse, compared to 2019 levels –in Vilnius and Tallinn. We assume a gradual increase in housing prices in 2025 and 2026 in Latvia and Lithuania, but prices are expected to grow somewhat slower than household income. With the strongest loss in real estate purchasing power in Tallinn, the market is slower to adjust in Estonia. The commercial real estate sector also largely avoided a broad-based price correction. Lower interest rates and gradually accelerating economic growth should increase activity in 2025 and 2026 albeit differences between specific sectors will remain.