Economic pain just starting for Baltic states

November 11 2008
Patrick Lannin and David Mardiste

RIGA/TALLINN, Nov 11 (Reuters) – Latvia’s rescue of its second-largest bank shows global turmoil has finally hit the Baltic region, but the pain is just beginning for the three former high-flying nations as a painful recession awaits.
As the countries’ currency pegs again come under the spotlight, the authorities are expected to hang on to them at all costs, but this means people face the prospect of a back-door “devaluation” and hardship via falling wages and prices.
The currencies of Estonia, Latvia and Lithuania are all pegged to the euro and stable exchange rates have been one of their economic bedrocks since the fall of the Soviet Union.

If that link were broken people’s debts would become much more expensive to service and confidence would take a huge blow.
Latvia is the most extreme example, with its yo-yo like economy expanding in double digits over the last two years and sliding four percent in the third quarter of 2008. The culprit is a huge influx of credit, which dried up in the global financial crisis.

But Lithuania and Estonia are also vulnerable to protracted problems.

“Latvia faces a very serious recession, it is only just beginning,” said Morten Hansen, economics professor at the Stockholm School of Economics in Riga. “It is only just beginning for all three (Baltic states).”

Latvia is now clearly seen as most risky of the three former Soviet nations as Standard & Poor’s on Monday downgraded the country’s debt rating to BBB- in the wake of the rescue of second-largest bank Parex, just one step away from junk status.
The fear is that Latvia will have to bail out more banks, putting an intolerable strain on finances, already feeling the impact of falling revenues with a rising budget deficit.

In the worst case, Latvia might need aid from the International Monetary Fund (IMF) or the European Union, though policy makers have said this is not on the cards at the moment.

Estonia and Lithuania are less vulnerable to bank problems as their financial sectors are more dominated by the Nordic banks like Swedbank, SEB and Nordea, whose presence in general in the region is seen as the ultimate rock of stability in terms of future lending.

Such a feeling was summed up by Estonian business daily Aripaev: “Thank God Estonia’s four biggest banks are owned by the big Nordic banks.”

But these banks have also felt the backlash of the global turmoil and are expected to be ultra-conservative in new loans for the Balts, meaning a new consumer-driven boom is unlikely. Export markets, even Russia, are also suffering.

“The bigger picture is that the legacy of the consumer credit boom has altered the economy to domestic demand and now it needs to re-balance towards exports, manufacturing, industry,” said Capital Economics analyst Neil Shearing.


Sustainability of the Baltic currency pegs is now being increasingly questioned.

However, a big currency mismatch as people borrowed heavily in foreign currencies, mainly the euro, during the credit boom, rather than their more expensive local currencies, means that a devaluation would be a personal financial disaster for many.

“They are in between a rock and a hard place,” said Shearing. The expectation of most people is that the central banks will fight as long as possible to keep the currencies pegged.”

What that means is that the structural alterations to make their exports competitive and lead to future growth will likely have to come through falling real wages and prices, leading to a slump likely to last several years.

“We could see a domestic ‘devaluation’ where the populations would have lower nominal wages, like we have seen in the airline industry, and we would need to see higher productivity and lower wage costs,” said Handelsbanken analyst Gunnar Tersman.

“The slump will not last a long time. It will not be a 10-year, Japan-like slump. The question is (whether) the cost levels are too high. But we are not in that position yet. It will take another year or two to know,” he said.

In the meantime, people are worried.

“Yes, I am worried, but not about the banks,” said Estonian mother of two Katrin Lilleorg, 31. “I am more worried about my husband’s job and our heating bills. I think it will be a hard time.” (writing by Patrick Lannin; editing by Tony Austin)