Global and Baltic outlook
We publish this report at a time of multiplying and overlapping challenges for the world economy. Since World War 2, the absence of wars in the affluent parts of the world and a sense of relative security supported the growth of prosperity. Russia’s invasion of Ukraine is the biggest threat to Europe in decades. It will have a profound global effects, - trade patterns will change, prioritizing security considerations and power politics over commercial logic.
The war in Ukraine and related sanctions are contributing to the raising trend in commodity prices that started already last year. In addition to high prices the supplies of other key commodities including metals (nickel, palladium) and food (wheat and corn) are limited. Business and consumer confidence has declined. Zero‑covid policies are causing a new wave of lockdowns in China that put supply chains under additional stress. China’s housing market is entering a slow moving, but potentially very serious crisis. There are signs of overheating in the US economy that could require strong monetary policy response. So sub‑par growth or even recession in all three main economic centers of the world might occur in our outlook period of 2022 and 2023. Thus external environment for Baltic economies will be difficult during the remainder of 2022 and early 2023. We can hope that during 2023 growth will accelerate as the world will hopefully leave behind the Time of Troubles of the first three years of 2020s.
The structure of this outlook is different from our previous reports. All other factors in the short run pale in importance comparing to the outcome of war in Ukraine and the related issue of sanctions regimes. In the long run, the future of Russia itself is of great importance for the Baltics. Thus these topics cannot be avoided, but due to their complexity and the “non‑economic” character of scenario drivers we place them in Annex.
Global macro conditions in general
Global economy was growing at above‑trend pace in the beginning of 2022, continuing to fill the pandemic output gap. In 2021 rich countries grew roughly three times faster than in a typical year, in 2022 growth rate was still expected to be roughly double the normal pace, though largely due to carry‑over effect. Now prospects look quite different.
There were warning signs already before Russia invaded Ukraine as US economy was showing signs of potential overheating, it was experiencing the highest inflation in 40 years (7.9% in February) and a tight labour market (unemployment rate has dropped to 3.8%). The Federal Reserve started to increase interest rates, reflecting on the possible view that monetary policy is somewhat behind the curve. As long‑term dollar rates remain quite low, reflecting moderate future growth prospects. Interest rate curve is briefly inverted at the very beginning of tightening cycle, but might revert back in the coming months. If inflation does not moderate sufficiently in 2022, there will be growing expectations that the Federal Reserve System will need to increase interest rates strongly and potentially cause sharp slowdown or even a recession to maintain policy credibility. Until recently long‑term inflationary expectations remained anchored, in other words, US breakeven 10Y rate remained below 3% almost all the time. The latest values indicate that also the future inflation rates may rise.
Policy shift is in the air also in Europe, but here it is much more cautious. In euro area there is still little sign of pervasive wage pressures, the preliminary inflation rate in March, though very high (7.5%) is still of more transitory character than in the USA as Europe is especially vulnerable to energy price hikes. Unlike in the USA where GDP has even exceeded pre‑covid trend, in euro area it still lags well behind it. GDP growth rate has been impressive recently (4.7% y/y in Q4, 2021), but that reflects favourable pandemic recovery effects. ECB in its latest (March) forecasts foresees 3.7% growth in 2022 in baseline scenario, but its underlying assumptions are becoming questionable as the economic sanctions widen, commodity prices stay high and supply chains are disrupted. We are writing this report at a time when situation changes very rapidly. Revelations of war crimes in Ukraine make the lifting of sanctions on Russia unlikely even if war ends soon as (probably unfulfilled) demands to hand over war crimes suspects are likely to follow. Thus the loss of Russian market and high energy prices are here to stay and recession in euro area becomes more and more likely.
In contrast to the Atlantic world, the two largest economies of Asia were cooling already at the beginning of the year. Even the extreme global cost pressures moved inflation up to 0.9% in Japan in February. China reported the same number but arrived at it from above. The long‑term slowdown of China’s economic expansion is continuing, its policy challenges are getting more complicated. Annual GDP growth rate declined to just 4.0% in Q4, 2021 (it was 8.1% in 2021, but largely due to favourable pandemic baseline effects).
Growth rate in emerging markets (ex‑China) had already settled to trend pace at the beginning of 2022. Future outlook for emerging markets is highly contrasting. While rising commodity prices is a positive for emerging markets on balance, rising the US dollar interest rates and the persistent pandemic impact on tourism constitute headwinds. Also the idiosyncratic policy‑induced troubles in Turkey where annual inflation reached 61% are worth attention as these could impact euro area, an important trade partner. Commodity importing countries (India, Egypt) will face acute challenges.
Major risks – war in Ukraine
Russia’s attack on Ukraine has probably killed tens of thousands of people at the time of writing and destroyed the sense of security for millions. While nothing compares to that, our report is about economic aspects and these are also important. Trade links have been hammered and supply chains are disrupted or in danger.
Global financial institutions (eg. OECD and the IMF) estimate that because of the invasion the euro area GDP growth in 2022 will be about one percent lower, even after government support programmes. The main channels of influence are the loss of exports to Russia and a disruption to supplies of commodities and intermediate goods. The loss of export markets is relatively minor and manageable as the country in 2021 represented 1.8% of the global economy (3.1% if measured at purchasing power parity, but that is less relevant for evaluating trade impact).
Ongoing and likely disruptions of commodity supplies present much larger potential risks. Russia is one of top 3 oil producers, its exports of oil and oil products represent roughly 8% of global consumption. Dependency of Russian natural gas is a major headache for Europe. There are grave dangers for specific industries, for example, the manufacturing of semiconductors requires neon, 70% of which is supplied by Russia and Ukraine.
While overall energy prices (S&P GSCI sub‑index) remained below historic peaks and declined since March 8 that was the peak of war‑related stress in financial markets, the prices of internationally trade food commodities are reaching new records. Here challenges are complex – the direct contribution of Russia and Ukraine in wheat markets (1st and 5th largest exporters respectively), the role of Ukrainian supplies in animal feed and the high share of Russian and Belorussian enterprises in fertilizer markets among others. Prices of some fertilizers have increased by 40% since February 24 from an already high level. The food inflation provoked by this conflict might set off waves of political instability in the emerging markets that can continue to roll across the world for years.
Unless radical political changes happen in Russia that make it a palatable partner again, the West will work very hard to cut its dependencies even if the war ends soon. There are ongoing efforts to replace potential shortfalls partly through additional supplies from Venezuela, Iran, there is also a chance of extra supplies from Saudi Arabia and US shale oil fields. Development of renewable energy will receive an extra boost that is already reflected in stock markets.
Public policies will partly mitigate the negative effects. While fiscal policy stance was moving towards deficit reduction priority as the pandemic is subsiding, investments in defense and energy transition will take priority over fiscal consolidation.
Major risks – China
While covid is receding in much of the world, it is presenting the most complicated challenge so far in China. It will be very tough to control the omikron variant with social distancing measures as it is exceptionally contagious. On the other hand, letting the virus spread would make a large number of people sick at the same time, as Chinese are immunized with local vaccines and have almost no acquired natural immunity to covid because of the zero‑covid policies in place. Currently the government is sticking with its zero‑covid approach that is necessitating lockdowns in key manufacturing regions and ports. The insistence on this strategy could cause profound disruptions to global supply chains as there is no viable exit strategy.
There is another crisis brewing that will set in more gradually and will be more manageable but could profoundly affect the global economy. The amount of housing construction in China is unsustainable and needs to be lowered from about 15 to 10 million units annually to avoid further accumulation of excess inventory. Mortgage loan issuance in China is falling for the first time since records begun. The value of bonds issued by high‑risk borrowers in real estate sector has declined steadily for over a year, but in March also investment rate issuers started to face rising financing costs. The sector is being shut out of financial markets, this process could become self‑sustaining. Systemic financial crisis in China is not expected, but significant growth driver will be lost. This is important as China consumes 50‑60% of key metals like steel, copper, aluminum and construction sector is that voracious beast at the heart of the economy. On the positive side, this will reduce demand for energy and certain industrial metals, freeing resources for energy transition that involves an increasing use of electrical equipment.
Baltics – common issues
The last year was more successful the Baltic states than initially expected. Estonia’s growth rate (8.6%) was amazing though largely determined by one‑off factors. Lithuania and Latvia expanded at near identical ~ 5% pace. Baltic economies continued their restructuring efforts, increasing the role of high‑tech services and goods in their export portfolios. The major bad news was a steady increase of inflation towards the end of the year, but the annual average (3.2% to 4.6%) was still tolerable.
The outlook for 2022 was quite good at the turn of the year, most forecasts clustered around 4% for all three countries (slightly lower for Estonia due to the large role of positive one‑offs in 2021), but currently we are looking toward very modest 1‑2% growth as economies suffer from direct loss of exports revenue, rising commodity prices, and lower consumer confidence.
It is very difficult to talk about prospects for 2023. If the war in Ukraine ends soon – in summer at the latest, GDP growth rate next year could be a high, above‑trend number as economies make up for missed opportunities in 2022 and positive effects of reconstructing Ukraine with European Union funds could lead to extra boost for Lithuania that has more business contacts in place. In the positive scenario Baltics would benefit from recovering consumer and investor confidence, and possibly falling energy prices – most likely because of additional supplies from other sources. Growth of public spending and investments, financed by EU funds is a positive factor that has been largely unaffected by recent events, it will strongly contribute to GDP growth in both 2022 and 2023. However, one can also imagine a scenario of prolonged conflict with deep damage to consumer and business perceptions, rapidly rising burden of military expenditure, possibly also disruptions to energy imports and various supply chain issues. The most recent developments make the relatively optimistic scenario more likely and we will continue to monitor the situation closely.
Unfavourable perception of safety of the region could become a barrier to long term growth. As negative security perception could become one of the main long‑term problems for the Baltic development besides demographics, info warfare is becoming an important economic policy tool. The security risk however is not new. Quite on the contrary, it can be argued that the Baltic security has actually improved since February 24, so there is a chance to turn around the views of external observers. Inherent weaknesses of the Russian army have been exposed, it is losing soldiers and equipment at a rapid pace, losing morale. The West has been mobilized politically and militarily, USA is sending more troops to Europe, Germany and other European countries will rearm, Finland and Sweden are moving closer to NATO. There will be extra defense spending in the Baltics. The war in Ukraine shows that there is the biggest relative advantage of defensive vs. offensive weapons in history. If small armies can cause a lot of problems for attackers if well supplied and motivated. Overall the outlook stays positive as the invasion has not been successful and Ukraine has defended itself well.