Mixed economic outlook for the Baltic and Nordic countries

By Gunnar Tersman, Senior Economist at Handelsbanken (Sweden)

Despite a difficult external environment, Estonia, Latvia and Lithuania have all made reasonable economic progress during the last couple of years. There are several reasons for the relatively positive results. While income per capita levels are still substantially below those in Western Europe, faster trend growth would normally seem a natural consequence as long as economic policies are supportive. A number of factors speak in favour of further convergence. The ample supply of highly trained professionals and skilled workers is no doubt a key element as well as the reasonably liberal business environment.

Also for cyclical reasons, we expect robust growth to continue during the next couple of years. Exports will benefit from the recovery underway in the euro area. While the deterioration in the Russian economy is having an impact on some exporting companies, the overall effects have so far been quite limited. Domestic demand is also a positive driver. Contrary to the situation in many countries in Western Europe, public indebtedness is low. The private sector has also ample room to borrow. Given the ultra-expansionary monetary policy pursued by the ECB to stave off the deflation threat, borrowing costs in the Baltic countries are very low. Firms and households obviously also benefit from low energy prices.

The situation in Russia is of course a particular concern for a range of companies in the region. As expected, the economy is contracting this year. Further out, we expect very low growth, even lower than what we are likely to see in the advanced economies. Given the central role of the energy sector, the fall in oil prices have had a huge negative impact on the economy. However, it is not the only factor. The sanctions imposed by the EU, the US and other Western countries have also played an important role. In addition, the general lack of confidence in the authorities’ policies among investors is clearly a strong deterrent to growth. Nevertheless, although Russia’s trajectory is problematic for a number of reasons, the economic effects should not be overestimated.

The Nordic countries are a rather diverse group. Denmark seems to have hit a soft spot after almost two years with continuous expansion. Low productivity growth, a lack of investment, high household debt and a lacklustre outlook in many important export markets are holding back growth. Finland is stuck in a vicious cycle, where weak competitiveness and poor corporate profitability are threatening to turn into a chronic problem of very low trend growth. Needless to say, the situation in Russia is also a drag on growth. Still, to a large extent, Finland’s problems are primarily of a domestic nature. Due to the fall in oil prices, the Norwegian economy has deteriorated at a faster pace than expected. Norges Bank is likely to ease its policy further as a result.

In Sweden, the economy is shifting into a higher gear and is likely to approach a cyclical peak next year. While exports will grow robustly on the back of a recovery in the euro area, domestic demand is expected to be the main driver. Given that demand is likely to expand at a faster pace than the underlying productive capacity, a positive output gap will gradually emerge. Domestic inflationary pressures are modest for the time being, but will play a more salient role ahead. However, since the Riksbank likely has an inflationary bias, the policy rate is unlikely to change until the end of next year. As the krona is likely to strengthen in anticipation of a more restrained monetary policy stance, the effects on the economy will be felt well in advance of that move.