November 15, 2008
I thought it was time with an update from the Baltic region. As small open economies, the Baltic countries have also been hit by the global financial crisis although the region has until now avoided the biggest tidal waves. As a matter of fact, many of the problems in the Baltics predate the recent financial crisis.
Within the last two weeks all three Baltic countries have released flash estimates of GDP growth in the third quarter 2008. It is depressing reading, cf. also the figure below. The two northernmost countries, Estonia and Latvia, are currently experiencing a very serious setback with output falling by around 3-4 percent year-on-year. Lithuania has been doing somewhat better during the last year, but growth is also here falling rapidly. The construction and manufacturing sectors are particularly hard hit.
The downturn is worrying, but perhaps not so surprising. Growth in Estonia and Latvia has until recently substantially exceeded the natural rate of growth, which has been estimated to be in the vicinity of 6-7 percent per year in the medium term. After several years of post-accession euphoria, it was unavoidable that growth would slow down. Growth in Lithuania never reached the euphoric levels of the two other Baltic countries, possibility because of an implicit revaluation in 2002 when the peg of the litas was switched from the dollar to the euro.
The surprise is not the drop in growth rates, but that growth has fallen so much below trend growth. My guess is that the countries have been hit by a cocktail of unpleasant factors, all pulling their economies down. The lending boom which fuelled growth in 2005-06 is long time gone; bank lending in real terms is flat or falling. The lending slowdown started long time before the international financial crisis and reflects that debt levels in firms and households had already reached west European levels.
Other adverse factors include the high oil prices which are particularly inauspicious for the energy-intensive Baltic economies. Foreign demand has also softened as the Nordic economies have slowed and competition from Chinese exports has remained strong. The external competitiveness of the Baltic countries has been held back because of excessive wage increases. Finally, various sanctions and boycotts imposed by Russia have meant that trade (and transit trade) with the Eastern neighbour has not developed favourably.
The immediate prospects are grim. Unemployment rates have been increasing in Estonia and Latvia with registered unemployment reaching 6.2 percent in Estonia in the third quarter and 6.3 percent in Latvia in the second quarter. The press is full of stories of workers having to take unpaid holidays or accept to work part-time. My guess is that unemployment could soon reach double digit levels in all three countries. The increasing unemployment is worrying since the social safety nets are relatively big-meshed in the Baltic countries. The end-result may be increased emigration.
Turning to the topic of financial stability, the news is mixed. First of all, the fixed exchange rate systems (currency boards Estonia and Lithuania, a tight fix in Latvia) have held up well. Occasional rumours of devaluations have died out fast. The governments have absolutely no appetite on changing the parities as most borrowing has taken place in euros or other foreign currencies. Currency devaluations would lead to terrible balance sheet problems with unforeseeable consequences. Moreover, the possibility of launching a speculative attack is limited by the shallow financial markets in the region.
The banking sector has held up well – at least compared to developments in Western Europe or the USA. Most of the banking sector is foreign owned and there have been no signs that the (mostly) Scandinavian owners will abandon their Baltic banking franchises. The only victim of the global financial crisis so far has been the second-biggest bank in Latvia, Parex bank, which was taken over by the Latvian authorities last week. The bank was majority owned by two Latvian individuals before the collapse. A few minor players have occasionally been rumoured to be troubles, but they are hardly of systemic importance.
Fiscal policy has been mostly passive and all three countries have been engaged in budget cuts for 2008 and have lined up further cuts for 2009. They will all end 2008 with moderate deficits well within the Maastricht deficit criterion. Their public debt is either non-existent (Estonia) or low (Latvia, Lithuania). The lack of counter-cyclicality in the fiscal policy is a matter of debate. On the one hand, it could be argued that the steep economic setbacks call for expansionary fiscal policies to make up for reduced demand from households and businesses. On the other hand, international financial markets are currently so volatile that even moderate increases in the borrowing requirements could lead markets to loose their nerves.
The outlook for 2009-10 is highly uncertain. Forecasts for all three countries generally assert that the economic downturn continues into 2009. For instance, the IMF project in the October 2008 version of the World Economic Outlook that growth in 2009 will be 0.5 percent in Estonia, -2.2 percent in Latvia and 0.7 percent in Lithuania. Recent events suggest that these projections may be too optimist. It is even harder to produce an outlook for 2010. It is noticeable, however, that growth rates in the Baltic countries have exhibited only moderate persistence in the past (see figure above). Growth has before dropped markedly, just to rebound a few quarters later. The Baltic countries seem to confirm the old insight by the Danish humorist Robert Storm Petersen: “It is difficult to make predictions, especially about the future”.