The Financial Times
December 29 2008
The fall from grace has been swift. Once lauded as free-market beacons for sclerotic “Old Europe”, the Baltic states are now seen as tinderboxes that could set off wildfires across the continent’s eastern half.
Latvia this month agreed a €75bn ($105bn, £72bn) stabilisation package led by the International Monetary Fund and the European Union to bolster confidence in its currency peg. There are fears that, were it forced to devalue, Lithuania and Estonia would have to follow and the repercussions would be felt in many other countries with fixed exchange-rate regimes.
In recent years the Baltic states have been among the EU’s best-performing economies, enjoying double-digit growth since joining the EU in 2004. But next year there will be contractions of between 3.5 per cent for Estonia and 5 per cent for Latvia and Lithuania, according to finance ministry projections – the worst outlooks in the 27-member bloc. The sudden change in the fortunes of the former Soviet republics raises the question of whether the Baltic “miracle” was just a mirage all along.
After a rocky transition from communism, the Baltic states restored economic stability by the end of the 1990s through fixed exchange rates and sound public finances.
Free-market reforms stimulated entrepreneurship and a wave of foreign investment, unlocking the advantages of being low-wage economies on the EU’s borders.
EU accession then unleashed a credit boom as foreign banks battled for market share by offering cheap euro loans to satisfy the pent-up demand for consumer durables, foreign cars and new apartments. House price inflation in Riga, Latvia’s elegant capital, peaked at nearly 60 per cent during 2006, while wages soared by 30 per cent as companies sought workers from a labour pool that was being depleted by migration to western Europe. At the same time, surging imports of consumer goods and weakening export competitiveness generated current account deficits of more than 20 per cent of gross domestic product.
When banks reacted to the deteriorating domestic and global environment last year by restraining credit growth, they pricked housing bubbles and pushed the Baltic economies into a sharp downturn. This accelerated as the global credit crunch worsened and the Baltics’ main export markets in the eurozone and Russia began to suffer.
Latvia was the weakest link because it had the highest current account deficit and external debt, and its public finances were in the worst shape. Crucially, unlike its neighbours, a quarter of its banking assets were also domestic-owned. When depositors lost confidence that Parex Banka, Latvia’s second-largest bank, would survive, the currency came under pressure and the government was forced to follow Hungary and seek IMF help.
Lithuania and Estonia are now cutting spending and resuscitating privatisation programmes to avoid having to knock on the IMF’s door.
Lithuania looks the most vulnerable because Estonia can draw on a budget reserve fund equal to 10 per cent of GDP. Lithuania’s new centre-right government has announced tough austerity plans but some analysts doubt it will be enough. “It would make a lot of sense for Lithuania to have a deal with the IMF and EU as part of a larger fiscal consolidation package,” says Lars Christensen of Danske Bank.
All three Balts are firming up plans to adopt the euro but are unlikely to be able to enter before 2012. All are desperate to avoid devaluation, which would increase the burden of euro-denominated debts and destroy confidence painstakingly built up over more than a decade.
Nevertheless, there will be a temptation to devalue as the recessions deepen. Growth in the Baltic states is not expected to revive strongly until 2011, which will delay their efforts to catch up with the rest of the EU and hurt foreign companies, notably Swedish banks, that have made sizeable investments there. How quickly the economies recover will depend on how much of the Baltic miracle survives – in particular, how swiftly industry adapts and whether governments can regain their reforming drive.
Baltic companies that have already come through two recessions are quietly confident that they can endure another. “We are survivors,” says Norman Bergs, chief executive of the Latvian company SAF, a niche player in microwave radio equipment. “We’ve survived 50 years of Soviet occupation so we can survive some turbulence in these years.”
There is also anecdotal evidence that the construction slump and returning migrant workers are easing tight labour markets and enabling companies to agree wage cuts. But too many companies, particularly in wood products and textiles, still rely on low wages to be competitive and need to move up to higher value-added production.
Governments have also neglected investment in education and research. This year all three countries slipped in the World Economic Forum global competitiveness ranking. “They were on an automatic convergence conveyer belt,” says Christian Ketels of Harvard Business School. “They didn’t build new competitive advantages, new strengths. Now they need to do this in a much less favourable environment.”
Yet the coming recession may now help focus minds. “It’s very difficult to get people to agree to deep reforms when the economy is growing 10 per cent a year,” says Andrius Kubilius, the new Lithuanian premier. “It’s really an opportunity to make these reforms that are really needed.”
Copyright The Financial Times Limited 2008