A little over two years ago, the Baltic economies embodied the worst of the global economic crisis that followed the collapse of Lehman Brothers. In 2009 GDP contracted 14% in Estonia and 15% in Lithuania, and it fell 18% in Latvia after huge credit and real estate bubbles burst.
So it is doubly remarkable that with the world bracing itself for a possible second wave of the crisis, the Baltics are not just recording strong growth, but are even being singled out by some commentators as examples of fiscal prudence to the crisis-ridden eurozone and debt-laden US economies.
Preliminary Q2 GDP data showed Estonia posted growth of 8.4% year-on-year while Latvia’s economy grew by 5.3% and Lithuanian GDP rose by 6.1%.
“Estonia, Latvia and Lithuania faced severe economic crises in 2008/09 and have shown that although it was painful to correct large macroeconomic imbalances and return to growth with a fixed euro exchange regime, it was not impossible,” says Michele Napolitano, an analyst at ratings agency Fitch.
According to Fitch, the Baltics unwound their large external imbalances through domestic demand contraction, and a decline in inflation and wage growth relative to trading partners. This internal devaluation was a painful process: these countries suffered a cumulative real GDP contraction of 18% in 2008/09. However, in 2011 their economies are recording fast rates of GDP growth, and external competitiveness and confidence in their solvency have also been restored.
Naturally, it is a source of some satisfaction for the region’s leaders that their tough approach appears to have given them much thicker armour in the event that the economic crisis does enter a second phase.
Estonian prime minister Andrus Ansip tells Emerging Markets in an interview: “We have to keep our finances in good shape, and that’s practically all we can do. When our finances are in good shape then it’s easier to survive all kind of difficulties we get from different countries.”
Ansip is adamant that Estonia’s accession to the eurozone this January 1 has not increased the risks his country faces – even if he can barely conceal his frustration with the spendthrift tendencies of the EU’s southern states.
He says Estonia is perfectly satisfied with the euro since it makes the country “even more attractive” for foreign direct investment. Although he is worried about the eurozone, he is optimistic that the group will ride out any new challenges. He believes the Baltic states are prepared too. He points to Latvia, which had a 50% deficit two years ago, which will be down to 3.8% this year and, he believes, 2.5% next year.
“That’s a success story,” he says, adding, “In Estonia last year we had a small surplus of 0.1% of GDP, and this year we will have a surplus once again. Our low levels of debt also mean we are better prepared.”
To Lithuanian prime minister Andrius Kubilius, an indication of the progress made comes from recalling previous meetings with his Baltic colleagues.
He tells Emerging Markets: “It’s clear that our topics for discussion have changed. In 2009 we talked about surviving the recession. In 2010 it was about getting a clearer picture, and [at our most recent meeting] we hardly talked about our economies at all. We have overcome a deep, deep crisis.”
Like Ansip he has some concerns for the eurozone but adds confidently: “We now have a recipe for national measures to account for any kind of global crisis.”
THE BALTIC APPROACH
As Kubilius himself points out, anyone wanting a quick resume of the Baltic approach only needs to read a recent book by Latvian prime minister Valdis Dombrovskis and Swedish economist Anders Aslund entitled How Latvia came through the financial crisis, which includes a list of nine lessons from the crisis including such intriguing examples as “the benefits of stable government have been greatly exaggerated” and “international macroeconomic discussion was not useful but even harmful”.
While the three Baltic nations imposed austerity regimes that by most measures were even harsher than the ones being introduced in Greece, Portugal and Ireland, there has been little by way of civil protest, with stoic Balts realizing that something had to give. Ansip increased his parliamentary representations at elections in 2010, while Kubilius survived mid-term local elections unscathed.
Dombrovoskis has faced the most severe backlash domestically, with his Unity party coming third in snap parliamentary elections on September 17, with the pro-Russian party Harmony Center winning the most votes, but not enough to form a majority.
At the time Emerging Markets went to press, though, it appeared likely that Dombrovoskis would form a coalition government with the second-placed Reform Party, which has pledged to stick by fiscal consolidation and euro adoption measures.
Speaking before the elections, Dombrovoskis was insistent that his policy course has left the Latvian economy well-placed to survive any renewed downturn.
“All the imbalances which were there have already exploded – we don’t have a real estate bubble, an overheated economy or rapidly expanding credit. We’ve regained competitiveness, financial stability and economic growth,” Dombrovskis told Emerging Markets in an interview before the elections.
He stressed that despite a GDP contraction totalling 25% over two years, the bigger picture is that in just two decades the Baltics have been transformed from Soviet command economies into some of Europe’s most flexible free markets.
EXPORT CONCERNS
“Certainly we’re better prepared than we were three years ago, but we do have a problem in that our recovery is strongly export-oriented. Export growth in the first half of this year was 37%, which means we are increasingly dependent on what happens in the global economy and especially in the other Baltic states, Scandinavia, Germany, Poland and Russia,” says Dombrovskis.
He recognizes that Lithuania may have to make adjustments to its strategy if the uncertainties in the markets and Germany’s weak growth cause further concern.
Analysts have warned that a slowdown in export demand would exert a significant negative drag on the region’s growth, despite significant improvements on the fiscal front. “Bad news from Europe will weigh heavily on growth this year and next,” Neil Shearing, chief emerging markets economist at Capital Economics, wrote in a research note on September 15, forecasting a slowdown in GDP growth to 2% in Latvia and Lithuania and 3% in Estonia in 2012.
The risk to exports is echoed by Danske Bank’s senior Baltic analyst Violeta Klyviene: “The high dependence on export growth reduces sustainable growth perspectives,” she says.
“Domestic demand in the Baltics will recover only based on strong performance from export-oriented industries. It is difficult to expect a rapid and strong recovery in the construction and real estate sectors today, although the potential growth of those domestic demand-oriented industries is quite strong.”
And though the Baltics followed similar trajectories out of the crisis, it’s important to note that they each used different strategies, which means a uniform outcome is by no means guaranteed. Estonia drew on the reserves it had accrued during the boom and concentrated on meeting the Maastricht criteria on euro adoption to bolster its reforming drive.
Latvia – which failed to amass reserves during the boom – turned to the IMF and EU for a E7.5 billion bailout programme but has arguably benefited even more from the expert advice and strict oversight provided by its international lenders than it did from the cash itself.
Meanwhile Lithuania chose a third path, issuing paper to finance its own way and regain the confidence of the markets. While that may not seem like a particularly radical option, it ran against the wishes of Swedish finance minister Anders Borg (Sweden’s banks are the biggest in the Baltic region) and other EU luminaries in 2009 who were pushing Lithuania to turn to the IMF, according to documents published by Wikileaks.
Overseeing Lithuania’s strategy has been finance minister Ingrida Simonyte. Estonia’s finance minister Jurgen Ligi won most of the plaudits last year by manoeuvring his country into the eurozone against expectations, but Simonyte’s cool-headed handling of the crisis has been just as important and made her a darling of the markets.
She says that internal devaluation and fiscal consolidation – albeit “painful and procyclical” – were the main tools to maintain the competitiveness of economy as well as the ability of the country to service its debts. “The ability of the economy to respond rapidly is one of the main assets, but fiscal policy must remain prudent, and structural balance must be respected in future to avoid rapid and severe procyclical adjustments needed to maintain the deficit within tolerable limits,” she adds.
She is not expecting huge credit inflows like those in 2005–2007 and sees prospects as more balanced than they were a year ago, but she recognizes that much depends on what is happening elsewhere in the world since the Lithuanian economy is “very open”.
EURO MEMBERSHIP
On the subject of the euro, it is possible to note a subtle shift of emphasis away from adoption at all costs to a more pragmatic approach given the zone’s continuing troubles.
“A currency peg to euro imposes a natural pressure towards factual membership of the eurozone, since the transitional regime cannot last for ever and FX risk cannot be mitigated otherwise,” says Simonyte. But she is clear that there are now costs to membership of the eurozone where once it seemed that there were only benefits.
“Our policy is still oriented to sustainably meeting the Maastricht criteria, rather than [targeting] the euro itself: having learned such a painful lesson during this crisis, we know that the Maastricht criteria are the minimum requirements each country should try to respect sustainably,” she says.
It’s a similar story in Latvia where the end of the bailout programme in 2012 will mean the country will need to start a refinancing cycle for 2014/15, so there will be no time for complacency, says Swedbank Latvia’s chief economist Martins Kazaks. The key, he maintains, is not to view euro adoption as an end in itself but – as was the case with Estonia – as a final certification of the reform process.
“If we do not manage to sort out the economy by that time, it will mean more expensive refinancing and a need to take money from the budget and pay it to foreign countries, instead of using it on developing our own economy,” Kazaks says, reckoning there is almost a one-in-three chance that worldwide GDP growth will be less than 2% this year, which would constitute the dreaded double dip.
But ultimately, as Danske Bank’s Klyviene points out, the Baltics show that smaller states can teach the larger ones a thing or two: “Today the situation is changing, and Europe has been reminded that they should follow the example of the Baltic economies,” she says.
“Fiscal consolidation, labour market and other structural reforms not only will not kill those economies, but will help them to become more competitive and finally stop the unsustainable growth of debt, which poses a threat to the entire eurozone.”