The Estonian Economy, No 2, 3 May 2011: Investment outlook strong despite uncertain construction sector

1. The Estonian Economy
Monthly newsletter from Swedbank’s Economic Research Department
by Elina Allikalt No. 2 • 3 May 2011
Investment outlook strong despite uncertain
construction sector
 Enterprise investments reported a strong increase at the end of last year.
Enterprises will continue to be the main force behind investments as the
recovering economy creates a need to renew production processes and
expand business activity.
 The residential real estate market has seen an increase in activity and a shift
in demand, thus making new development projects focus more on quality.
Although prices are already rising, any further rapid increase in dampened by
still-weak labour market conditions and idle boom-time real estate.
 The construction sector has been slowly recovering, supported by public
sector infrastructure projects, while private sector activity is expected to
increase more notably starting next year. Rising wages and construction
prices pose the biggest risks to further construction sector recovery and,
eventually, to investment outcome.
So far, the economic recovery in Estonia has been Enterprises are renovating and expanding
founded mostly on increased export demand, and
Enterprise investments, which dropped sharply
this trend is expected to continue in the first half of
during the recession years, showed a strong
this year. However, our latest forecast sees
recovery during the last quarter of 2010 (18%
domestic demand, supported heavily by
growth in the last quarter compared with an
investments, recovering substantially, becoming by
average decline of 20% during the first three
the end of this year the main contributor to growth
quarters of the year). Improving economic
and maintaining that role throughout at least all of
confidence has pushed enterprises to carry out
next year.
investments that were delayed during uncertain
times; also, constraining production capacities are
Contributions to GDP growth
(percentage points) pointing to the need to renew and renovate
production processes and move up higher on the
15%
value chain. This was best reflected in equipment,
10% machinery, and inventory investments, which
5%
increased by 57% in annual comparison in the last
quarter and reached levels almost as high as those
0% seen during 2006-2007. The economic sectors
-5%
2006 2007 2008 2009 2010 2011f 2012f increasing their investments the most in this
category are the ones that also contributed most
-10% strongly to export growth--e.g., energy supply,
-15% manufacturing (including electrical equipment and
wood and food product industries),
-20%
telecommunications, and domestic trade. Also,
-25% investments concerning the acquisition and
Households Gov ernment construction of real estate (buildings, structures) are
Inv estments Net exports
Changes in inv entories GDP steadily increasing as cheap bankruptcy assets are
Sources: SE, Swedbank f orecast
Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000.
E-mail: ek.sekr@swedbank.com www.swedbank.com
Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720.
Annika Paabut, +372 6 135 440. Elina Allikalt, +372 6 131 989.

2. The Estonian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
Nr 2 • 3 May 2011
still available in the market and construction prices even some signs of a hold-and-wait attitude from
have fallen considerably. sellers in hopes of a fast price increase. Alongside
the new developments, poor-quality low-priced
Looking ahead, enterprise investments are the main
boom-time real estate is still available on the supply
force behind our expectations of strong investment
side; hence, the difference in price levels in regards
growth. There have been many major projects
to quality will become more pronounced.
announced recently which are still in the
development process (including several retail sector Real estate price index
expansions, as well as investments by state-owned (Index, 3Q 2003=100)
companies), but these are expected to be put into
3.5
operation starting next year. As the economic
recovery has mostly been export led, investments 3.0
have so far been growing mainly in export-oriented
sectors. However, we can expect domestic sectors 2.5
to strengthen this year, with economic growth
2.0
becoming more balanced within sectors; this, in
turn, will generate investment incentives for those 1.5
enterprises as well. Building capacity is crucial for
enterprises, as otherwise competitiveness may 1.0
weaken going forward.
0.5
Investments in tangible fixed assets of enterprises 2004 2005 2006 2007 2008 2009 2010 2011
(million euros) Real estate
Apartments
400 800 Immov ables without buildings
Residential land with buildings Source: Estonian Land Board
350 700
300 600
The number of new development projects is
250 500 expected to increase, although there are some
200 400 factors limiting a faster recovery in demand and
150 300 household investments. Most of these concern
100 200 labour market conditions – incomes are continuing
to fall in real terms, and unemployment, although
50 100
declining, is still at a high level. These factors also
0 0
limit the eligibility for loan financing. Many
2004 2005 2006 2007 2008 2009 2010
households are also stuck in a „real estate trap“
Total (rs)
Acquisition, constraction, alteration of buildings, structures
with their current homes, which, bought with loan
Vehicles money at high prices during boom years, now have
Equipment, machinery , inv entory
Other
much lower market values.
Source: SE
Apartment median m2 price ratio to net wage
Residential real estate: strengthening 3.0
demand, mismatched supply
The real estate market stabilised in 2009 - when the 2.5
bottom of the market in terms of the number of
transactions as well as prices was reached - and 2.0
started showing some early recovering signs in
2010. Although during the past few years the 1.5
demand side was more focused on low prices, it
has more clearly now shifted towards good quality.
1.0
As a result, many new development projects have
been very successful due to their focus on good
location and developed infrastructure; high-quality 0.5
projects also have a better chance to get additional 2004 2005 2006 2007 2008 2009 2010
financing. In line with the increased activity and shift Estonia Tallinn
in demand, the average prices of sold-purchased Sources: Estonian Land Board, SE, Swedbank calculations
residential real estate have risen, and this small
upward trend is expected to continue; there are
2 (4)

3. The Estonian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
Nr 2 • 3 May 2011
Imbalances ahead again in construction construction sector activity has recovered more
sector? quickly in other countries; thus, the probability of
finding a job elsewhere, as well as wage levels
The recent sharp contraction of the construction elsewhere, are much more attractive than in
sector and falling construction volumes have now Estonia. According to confidence data, the number
stabilised, as confidence has been improving for
of companies claiming the shortage of labour to be
more than a year. This recovery, however, has
the main factor limiting their business activity was at
been founded broadly on public sector projects
its highest level in two years in April. Another
(especially EU-funded infrastructure projects), while
troubling development is the acceleration of wage
construction of buildings is still lagging. This trend is
growth to levels higher than productivity gains (see
on average expected to continue this year, with
chart), leading to a loss in competitiveness.
private sector construction activity recovering more
noticeably starting next year, as many expected Actual employment and expectations in construction sector
projects (especially nonresidential projects) are now
50% 60
in a preparatory phase.
40%
40
Construction volumes
30%
(annual growth)
20
60% 20%
10% 0
40%
0% -20
2005 2006 2007 2008 2009 2010 2011
-10%
20% -40
-20%
0% -60
-30%
2004 2005 2006 2007 2008 2009 2010
-40% -80
-20%
Employ ment, annual growth
Employ ment expectations (rs) Source: SE, DG ECFIN
-40%
Productivity and wages in construction sector
-60% (annual growth)
Source: SE 25%
Total Buildings Civ il engineering
20%
Despite the slow recovery, there are already many
indicators suggesting that the imbalances seen 15%
during the recent boom times might return to the
10%
construction market sooner than previously
anticipated. Construction sector real wage growth 5%
was slightly positive last year, registering 0.7%
growth, while overall wages continued to fall by an 0%
2006 2007 2008 2009 2010
average of 2%. Further more ,annual wage growth -5%
accelerated to 5.3% in the fourth quarter, the
second-highest rate after the mining sector (which -10%
is struggling with a labour shortage) and much
-15%
higher than the overall average of a -1.3% decline;
Productiv ity Real gross wage
construction price index data points to another Source: SE, Eurostat
strong increase at the beginning of this year. This,
on one hand, indicates a possible change in the Accelerating wage growth creates extra pressures
structure of employment (low-skilled workers for increasing construction prices, which, in turn,
downsized after the boom vs. higher-skilled workers eventually affect investments. Construction prices
demanded now); on the other hand, it also suggests have been growing since the last quarter of 2010,
that the labour emigration in that sector during founded heavily on a pickup in labour costs, while
recent years might have been higher than other inputs (machinery and material) have grown
previously estimated (there are no official data only marginally. Confidence figures have shown
available on this). At the same time, the pressure increasing expectations of price growth for more
for construction workers to leave continues because than two years now (see chart), reaching very high,
3 (4)

4. The Estonian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
Nr 2 • 3 May 2011
Construction prices boom-time levels at the beginning of this year. Of
(annual growth) course, there might be some overshooting in price
30% 80 expectations due to the steadily recovering
confidence; nevertheless, this also points to existing
60
20% imbalances in the supply side—e.g., not only the
40 already-mentioned shortage of skilled workers, but
10% also companies’ wish to increase profits as
20
construction volumes grow. If price growth
0% 0 accelerates again to unsustainable levels, this will
2005 2006 2007 2008 2009 2010 2011 inevitably create imbalances and have a restraining
-20
-10% impact on investment and construction volumes.
-40
-20%
-60
-30% -80
Total
Labour
Price expectations (rs) Sources: SE, DG ECFIN
Elina Allikalt
Swedbank
Economic Research Department Swedbank’s monthly newsletter The Estonian Economy is published as a service to our
SE-105 34 Stockholm customers. We believe that we have used reliable sources and methods in the preparation
Phone +46-8-5859 1028 of the analyses reported in this publication. However, we cannot guarantee the accuracy or
ek.sekr@swedbank.com completeness of the report and cannot be held responsible for any error or omission in the
www.swedbank.com underlying material or its use. Readers are encouraged to base any (investment) decisions
on other material as well. Neither Swedbank nor its employees may be held responsible for
Legally responsible publisher
losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s
Cecilia Hermansson, +46-8-5859 7720
monthly newsletter The Estonian Economy.
Annika Paabut +372 6 135 440
Elina Allikalt +372 6 131 989
4 (4)