The three Baltic economies face a spiralling economic downturn

The Economist

April 8, 2009

ONCE the fastest-growing economies in Europe, the three Baltic countries are now the opposite. Latvia, which in December received a €7.5 billion ($10 billion) bail-out led by the International Monetary Fund, is basing its budget on a 13% decline in GDP. Estonia and Lithuania expect a decline of a tenth. A conventional response might be devaluation and fiscal stimulus. But the Baltics’ currency pegs to the euro are a matter of national pride. Moreover, most private borrowing is in euros, so devaluation would mean beggary for many. Instead, the response has been wage cuts meant to regain competitiveness.

Fiscal stimulus is tricky too. Estonia ran a budget surplus during the boom, so has some room for manoeuvre, but even it can risk only a deficit of 3% of GDP permitted by the rules for joining the euro. All three countries want to adopt the single currency as soon as possible, though not by bending the rules: the whole point is to gain credibility, not to enter the club “on a stretcher”, as one official puts it. But as economies shrink, it gets harder to meet deficit targets. Latvia’s new government has been haggling over a 5% ceiling agreed with the IMF, missing last month’s €200m instalment of the bail-out as a result.

The Baltics have no shortage of external support. The European Bank for Reconstruction and Development this week agreed to bail out Parex, a Latvian bank. The IMF has more money to help. But the economic adjustments are still unimaginable in old Europe. Having soft-pedalled reform after joining the European Union, the Baltics now have to make up for lost time, in a climate where they are perilously exposed to the global downturn.

Belatedly, some progress is visible. Inflation and current-account deficits are falling. Latvia has begun unpicking a network of sinecures in nationalised industries. But overdue reforms such as simplifying local government in Estonia are still on hold. Yet compared with the polarised politics and debt-soaked economy of Hungary, the Baltics’ outlook is not bad. None of the three is much exposed to the international financial markets. Their stocks, bonds and currencies are thinly traded. Most of their external debt is owed by local bank branches of Swedish parents. Bits of those loan books have soured, particularly in property and construction. But other parts are still sound. So long as the Scandinavian banks stand by their investments, the Baltics should be all right.

Public protests have been muted and peaceful except for two bust-ups in Lithuania and Latvia. Estonia’s politics look the most solid, with a well-regarded coalition government. Latvia’s government, in office for just a month, is more broadly based than its predecessor and has shed some incompetent figures. Lithuania faces a presidential election in which the front-runner is the EU budget commissioner, Dalia Grybauskaite. Her financial skills may soon be tested, since after the election Lithuania may well turn to the IMF for help.

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