Challenges for enterprises and trends in the Estonian economy

Lenno Uusküla

Luminor Eesti, Chief Economist

In the last few year the Estonian economic climate has been challenging, but enterprises have remained resilient. Although instead of growth the economy has been shrinking for several years, developments in some economic sectors are providing opportunities for enterprises to adapt. Factors affecting Estonian companies include low demand, rising costs and labour market challenges. For enterprises, one of the key issues is now efficiency growth, and meeting the requirements for the green transition is equally important. Fortunately, strong financial situation has allowed enterprises to survive.

The economy is expected to rebound in 2024. Even a recession of one percentage point means that the economy needs to grow by a percentage point within a year in order to remain at the previous year's average. Prices are growing much less than in previous years, which is now mainly attributable to tax changes. The unemployment rate is reaching 8 percent, mainly due to the inclusion of Ukrainian war refugees in the statistics. At the same time unemployment is growing also among local people and more people are willing to commute over larger distances. The rise in unemployment means that in two years we have not succeeded in integrating these people properly into the labour market and they continue to have difficulty in finding jobs.

Role of export and applicable strategies

Weak demand in foreign markets, especially in Sweden, Finland and Germany, has reduced the opportunities for enterprises operating in traditional manufacturing industries. The recession in the Swedish real estate and construction sector has already affected Estonian exporters directly. In addition, the problems of German car makers and the general slowdown in the production of capital goods in China and, as a result, elsewhere, have reduced the potential of the markets. Since Estonian exporters are small, it is often difficult to find new markets because there is insufficient knowhow, courage or resources to expand to new markets.

However, in Estonia one must keep in mind that in order to maintain export capacity, it is necessary to increase efficiency, while price increases and labour costs remain high and keep growing. As the export of services is not as dependent on physical borders and geographical distance as the export of goods, the share of services in foreign trade has increased and continues to grow. But this also requires large investments and a change in the corporate structure, which is often not possible within one company, which means that new companies need to find markets in new areas.

Green transition and energy security

The energy crisis, rising costs of CO2 quotas and green transition requirements are forcing enterprises to pay more attention to the development of green energy and sustainable production. The green transition is particularly and directly relevant for industrial and manufacturing companies that depend on energy-intensive production processes. The lack of investments in energy-generating capacities in the past has created a situation where Estonian enterprises are forced to pay more for energy and have limited access to clean energy, which hampers competitiveness and attracts new investors. The high cost of CO2 and the requirements for green turnaround require innovative solutions from enterprises, but their realization often means large investments that many small and medium-sized enterprises cannot afford to finance themselves, especially if their competitors receive state support for their investments in other markets.

Therefore, the changes needed for the green transition require political backing and support measures. However, without clear public policy guidelines and long-term support, companies will remain waiting to see what trends emerge and how they could affect their operations. However, the time spent for waiting often means a loss of competitiveness.

Labour market and wage growth

The situation of enterprises selling to the domestic market is rather good. Prices have gone up faster than wages and has allowed them to make a profit even at low demand. For exporters, however, the situation is challenging, as wage growth in Estonia exceeds most target markets and other manufacturers. The only exception where wages have grown faster than in Estonia are Latvia and Lithuania, but even there the main wage growth comes from the public sector, not from private companies, and the wage level in both countries remains lower than in Estonia.

At the same time, the outlook is full of challenges. Although wages continue to increase, it has not compensated for the rise in the cost of living, and real wages are still about 4 percent lower than three years ago. Wage growth has been slightly faster among lower-paid workers, which has somewhat helped to reduce income inequality, but has also put companies whose productivity is lower under more pressure, as they often pay lower wages. Recruiting and retaining highly skilled workers remains a major challenge, as labour shortage is particularly evident in high-tech and innovation-focused companies.

Investments and consumption

The fall in interest rates has opened up some opportunities for enterprises, but in the current economic situation, companies’ readiness to borrow remains limited and enterprises are often hesitant to go ahead with expansion plans. The startup sector, which until recently attracted significant investments, has run into financial difficulties, as investors can get a return for their money from elsewhere without taking risks related to startup companies. Rising interest rates have also slowed down real estate investments and put pressure on renting of office space, also increasing the overall cost base of companies. After the coronavirus, only some enterprises have told all their employees to return to the office, but since the companies are still undecided if and when they want to see all employees back in the office again, the demand for rental space has not decreased significantly.

Difficulties in making long-term investments and the volatility of economic policy steps have increased lack of confidence among businesspeople. The ambiguity of the economic and tax environment is affecting the development of all business sectors, as the government remains unpredictable in its economic policy decisions. However, investment growth remains one of the pillars of the economic recovery, and growth in investments may put the economy back on track for growth.

On the domestic market Estonian enterprises are affected by the decline in both purchasing power and consumption. Sales volumes are decreasing in all retail trade categories, especially in durable goods, but sales of second-hand goods and the volume of repairs are growing.

Trends and strategies for economic recovery

In this challenging environment for the Estonian economy, enterprises also see opportunities to adapt and develop strategically. The green transition and digital solutions are expected to continue growing, but achieving their goals will require new investments and flexible business models as the process is full of unexpected twists and uncertainties. In addition, growing protectionism in international trade, both by China and the US, and the quest to be strategically independent due to geopolitics, may lead to the restructuring of key economic sectors. So far it seems to have benefited the US, but not Europe.

The economy will continue to grow at a modest pace next year. The state budget will remain in the deficit, supporting the economy. Private consumption continues to shrink, as the amount of free funds in the purchasing power will decrease due to rising income tax and inflation. Limited relief should come from the continued decrease in interest rates and which is starting to reach loan payments. This process will continue also next year. Unemployment in Estonia is slowly increasing, as companies need to become more efficient in order to survive, while there are still not enough young people and to many pensioners that keeps the overall unemployment from increasing. There are risks in both directions. With stronger recovery of the euro area and a the Swedish real estate sector becoming more robust, Estonian enterprises should receive more business than is currently expected.