Swedbank Economic Forum: The world economy is having a rebound, productivity is the cornerstone of sustainable growth

At the end of May Swedbank organized an economic forum, where six influential economists of Northern countries, as well as Economics Professor Enrico Moretti of the University of California (Berkeley) and ex-Prime Minister of Latvia Valdis Dombrovskis discussed issues catching minds of today’s businessmen, economists, politicians and the community in general.

Two important topics were the focus of the discussion:Firstly, is European economy finally having a rebound, or should we expect a long-term stagnation?Secondly, what fosters and will foster economics in years to come?

Persons, who shared their thoughts, observations and forecasts about these issues:• Harald Magnus Andreassen, Chief Economist at Swedbank Norway• Valdis Dombrovskis, ex-Prime Minister and newly elected European Parliament’s

deputy• Anna Felländer, Chief Economist at Swedbank Sweden• Tõnu Mertsina, Chief Economist at Swedbank Estonia• Mārtiņš Kazāks, Chief Economist at Swedbank Latvia, and Lija Strašuna, Senior Economist at Swedbank Latvia • Nerijus Mačiulis, Chief Economist at Swedbank Lithuania• Enrico Moretti, Professor of Economics at the University of California (Berkeley)

In this magazine we offer for your attention the most significant considerations of the forum. Forum video:https://www.swedbank.lv/tiesraides/baltija_un_pasaule_kas_notiek_ekonomika

If you have any recommendations, considerations or observations, which might help us to organizenext Swedbank economic forums, do not hesitate to send them to this e-mail: lija.strasuna@swedbank.lv

Enriko MorettiProfessor of Economics at the University of California (Berkeley)

Productivity = standard of living

Baltic countries are small open economies with the level of earnings significantly differing from the average EU level and having access to free workforce movement within the EU. Except for recession periods, wages are growing and will continue to grow. If productivity growth lags behind wage growth, in recession periods the labour market can overheat, which will be followed by emigration. Therefore, the growth of work productivity is a decisive factor for dynamic and sustainable income growth. Our special guest Enrico Moretti, Professor of Economics at the University of California (Berkeley), told about the latest global trends in productivity growth and its drivers.• Vast differences in productivity levels are related to two factors: level of education and innovation. The

experience of the United States, Europe and Asia shows that the cities and regions concentrating highly educated labor force, namely, educated persons and innovative companies, have the highest standard of living.

• The main source of productivity growth are the so-called traded sectors, namely, the sectors, where goods/services can be traded and face national or global competition (such as industry, transport, agriculture, etc.). These factors are those, which determine the total economic productivity level and therefore the level of earnings.

• Productivity in the sectors, which mainly work for the domestic market and provide non-traded services (waiters, hairdressers, lawyers, doctors, etc.), does not improve productivity by itself in time.

• Non-traded sectors gain from growth in traded sectors. For example, observations in the United States show that each (well-paid) job in a high tech company (such as in the information technology or pharmaceutical industry) creates five other jobs in the service sector, but not vice versa.

• The development of traded sectors promotes the development of the entire surrounding region, raises the total wage level and improves the standard of living in general. The attraction of such companies is the biggest challenge for the economic policy of each state. If you want to help low income people, one of the best solutions would be to support creation of highly qualified and well-paid jobs.

“According to my estimates each job in the innovative sector creates five new jobs in other national economies. This is a huge effect.”

/Enriko Moretti, interview to Ir magazine/

“Technological progress and digitalization provide us big opportunities, yet they can raise inequality – people with better education and skills might have more benefits.”

/Anna Felländer, Chief Economist at Swedbank Sweden/

Aigars Rostovskis,

Vice President of the Latvian Chamber of Trade and Commerce:

The further development scenario of China will largely determine the events in many parts of the globe, because changes in such a significant economy will create truly global consequences. The question is when, what and how wide changes are expected in China? Secondly, the events in Russia are a significant factor for the Latvian economic development.

Key considerationsOpinions of forum’s visitors

China is the major risk for global economic development

When evaluating processes in the global economy, Harald Magnus Andreassen, Chief Economist at Swedbank Norway, emphasizes that the world economy is generally having a rebound. Despite the risks for the global economy from processes in China, Mr. Andreassen is optimistic. He encourages to recall that the world experienced recessions only less than 15% of the time in the past decades, while continuous economic growth has been observed for the rest of the time.• In the last six years, the United States and European countries resolved many economic problems, and not too

many new were created. The process of reduction of credit liabilities in the private sector is largely behind us – investments are on the way up, but still low, savings are high.

• Public sector fiscal consolidation is behind us and the state debt is stabilising. There have been significant structural changes in Eurozone bodies – banking, fiscal policy, stability mechanisms.

• Wage inflation is at 1 – 2% per year, therefore no significant consumer pricing inflation is expected in the near future, yet deflation risks are also exaggerated.

• Today China can potentially create major risks for the global economy. A significant growth of debt of the private sector, an activity drop in the housing market and more expensive financing for businesses raise doubts regarding further development. However, it should be noted that China is not closely integrated into global financial markets (incl. it mainly borrows in its domestic market) to cause a crisis, which the world experienced after the breakdown of Lehman Brothers/

Haralds Magnuss AndreassenChief Economist at Swedbank Norway

“Your [Baltic States’s, ed.] current challenge is labour productivity which is below the European level (..) Economies, where productivity is below the European level, should simply have sectors to be improved, and education is evidently one of such sectors.”

/Harald Magnus Andreassen, interview to Dienas Bizness newspaper/

Baltic countries gazing at the events in Russia and Ukraine

Economists from Baltic countries are now more focused on the events in Russia and Ukraine. Mārtiņš Kazāks, Chief Economist at Swedbank Latvia, thinks that this year the Russian economy will be in recession. However, the Russian ruble has slightly recovered after a period of weakening, and financial markets show stabilization.Swedbank economists think that in case of the base scenario (which is the most credible scenario) – if sanctions to Russia remain at about the current levels – the events in Ukraine and Russia will have no significant negative impact on the growth of European economies. The worse scenario would implement, if the conflict in Ukraine became harsher, broader sanctions to Russia were introduced and Russia retaliated by explicit trade barriers and interrupted/reduced energy supplies. In this case a hike in energy prices would reduce growth in Europe as well, Russia would fall into deeper recession and cause more negative spill-overs to other CIS economies.• If China is a risk for the global economy, then the events in Russia are a bad news for the Baltic countries. Russia

is weak to create growth – the unemployment rate does not shrink any more, the growth in earnings has become more gentle, therefore people will earn and spend less. Lack of reforms to promote growth. Capital outflows and higher interest rates mean weaker investments.

• Russia is expected to have shallow recession this year, however the economic situation is not a late 1990s case. It can have slow recovery in 2015.

• In general, the Russia-Ukraine conflict, as well as the recently signed contract on Russian natural gas supplies to China confirms that Russia currently turns its back to Europe and is looking to Asia, while Europe turns towards the United States.

Latvia’s goods’exports to Russia in 2013, % of total goods’in the specific sector

Mārtiņš Kazāks Chief Economist at Swedbank Latvia

“Taking into account very weak development of the Russian economy, the Baltic countries will also show slower growth. However, direct influence will be focused in a few sectors only such as transport, tourism, separate food processing sectors. It is expected that the drop in exports to Russia will be compensated by a rise of exports to Europe and other countries, which are growing.”

/Lija Strašuna, Chief Economist at Swedbank Latvia/

Tõnu MertsinaChief Economist at Swedbank Estonia

Recovery of exports is expected in the Baltic countries

Estonia has the weakest economic situation among the Baltic countries right now, where GDP in the first quarter was by 2% lower than a year before (Latvia and Lithuania showed about 3% growth). Tõnu Mertsina, Chief Economist at Swedbank Estonia, suggests that this year Estonia will go into small recession, Estonia’s economic growth forecasts for this year might reduce. The fast wage growth in Estonia will hinder, but the Estonian economy will return to growth when export prospects improve.• Economic growth in all the Baltic countries largely depends on exports. Despite the fact that household

consumption is the main growth driver now, if exports do not help, the household consumption growth will gradually fall. However, as growth in the Eurozone cumulates momentum, the demand for the goods and services exported by the Baltic countries will grow, and economic growth in Estonia, Latvia and Lithuania will accelerate again in 2015.

• As the unemployment rate continued to drop, all the three Baltic countries experienced a significant wage growth last year, – the nominal mean wage growth in Estonia reached 8%, and in low inflation conditions real mean wage growth was also significant. If wage growth continuously outpaces productivity growth, this negatively affects national competition and may hinder growth with time. This is one of the most important domestic risk factors in all Baltic economies.

Key considerationsOpinions of forum’s visitors

Elīna Stengrēvica,Chief Editor of Ir Nauda magazine:

Speaking about the future: economic growth is not possible without productivity cultivation. How to achieve this? It mainly depends on education and innovations, creation of new products. Latvians do well, because the total number of patent applications per employee in Latvia is higher than in Lithuania and Estonia. Valdis Dombrovskis mentioned that in the near future a higher growth in the assimilation of European funds is planned for innovation and research. However, not only the public sector, but also businesses should invest into research and development – this process is quite inert in the Baltic countries right now.

Lithuania and Latvia should get down to promotion of innovations immediately!

Convergence of the Baltic countries with the European Union (EU) has been impressive – in case of Latvia the level of income grew from 45% of the EU average in 2004 to the current almost 70%. Lithuania and Estonia showed a similar growth. If the level of earnings continues to make its way to the EU average at the same pace in the next decade, the standard of living of the population in the Baltic countries would reach the EU average by 2023-2025. However, Nerijus Mačiulis, Chief Economist at Swedbank Lithuania, believes that for several years the previously fast movement of earnings of the population in the Baltic countries will continue at a significantly slower pace (it might be around 1% per year). Promotion of innovations is one of the biggest medium-term challenges for Baltic economies. He draws particular attention to insufficient investments into research and development in Latvia and Lithuania.• Lithuania and Latvia invest 2-3 times less in research and development than the EU average. The level of

investments in Latvia makes just 0.7%, in Lithuania – 0.9% of GDP, which significantly lags behind the current European level (about 2%) and the European target to achieve 3% by 2020. Moreover, if we evaluate investments by businesses only, the situation is even worse – they even do not reach 0.5% of GDP in Latvia and Lithuania.

• Demographic trends, quality of education, as well as institutional and business environment quality and effectiveness is also a significant challenge for the Baltic countries.

Nerijus MačiulisSwedbank galvenais ekonomists Lietuvā

“Demographic trends, including a drop in the number of persons capable of working in the Baltic countries is a challenge, and we need adequate economic policy decisions to resolve them.”

/Nerijus Mačiulis/

R&D expenditure in 2004 and 2012*, % of GDP

Tax changes should support Latvian competition and reduce inequality of earnings

Latvia has one of the lowest tax burdens in the EU, the total tax burden in Latvia is low, yet taxes are high for lower paid workers. Valdis Dombrovskis, ex-Prime Minister and newly elected European Parliament’s deputy, believes that this is the question, which should be resolved as a priority in the context of national competition. At the Swedbank Economic Forum, the ex-head of the government explained that there were changes in taxes, for example, the ceiling of social security contributions for highly paid workers was reintroduced, because otherwise Latvia was not competitive in the sector of well-paid employees in the context of Lithuania and Estonia, however there is a lot to do.• Tax changes should be more focused, namely, Latvia cannot afford across-the-board tax cuts, however, we need

to concentrate on those sectors, which promote competition and reduce inequality. Lower paid workers are the primary target of tax cuts.

• Wage growth in Latvia should be monitored and we should not return to the pre-crisis situation, when the increase of wages in the public sector stimulated wage growth, and wage growth exceeded productivity growth many times. Now the private sector is the driver of wage growth in Latvia, and we should go on in the same way – wage growth in the public sector should follow the private sector.

• The internal EU market is well developed in the sector of goods right now, yet it is not so in the sector of services. EU can increase growth by fully implementing the Services Directive, by simplifying and developing the provision of services in the internal market

• Digital market is another question to be resolved. Today, the EU has 28 different markets, each of which is trying to develop digital services, however, they should be developed at trans-border level – electronic documents, the possibility to use electronic signatures should be developed.

Valdis Dombrovskisex-Prime Minister and newly elected European Parliament’s deputy

“To have some shift in tax policy we need some kind of societal consensus, but we are not there yet. If there is enough demand for larger budget, I think we will be able to ensure it.”

/Valdis Dombrovskis/

Ģirts Rungainis,

Prudentia partner, Council member:

Individual competition of persons is and will be the decisive factor for the development of any state. Having regard to the fact that this requires investments, the ability to raise capital will become a significant condition. Latvia will continue to lose people, if no adequate investment raising level is reached.

Key considerationsOpinions of forum’s visitors