By Guy Norton
The boom years for Estonia, Latvia and Lithuania are over. But just how severe a downturn they face depends crucially on how quickly policy-makers respond
At first glance Tallinn, Riga and Vilnius have little in common with Lisbon. But all three Baltic states run the risk of falling into the so-called Portuguese trap: after years of rapid economic convergence with high credit, wage and income growth, the latter’s economy took a turn for the worst, and since 2001 growth has been sluggish and the economy has yet to pick up.
The danger of an economic bust following the boom years since 2000 in the Baltics has been attracting the keen scrutiny of supranationals, rating agencies and economists alike. The IMF, for example, has identified four elements of a policy package that it believes can help the authorities in the Baltics to engineer a soft landing rather than an economic crash in the region.
First, it says, governments have to tighten fiscal policy even if the countries enter a period of slow growth.
Second, they should facilitate the switch of production and investment to tradable (manufacturing, tourism) from non-tradable sectors (real estate) via tax policy. This is particularly important in the Baltic States where easy credit has fuelled housing bubbles. These are threatening to burst as the supply of cheap money has been switched off in the wake of the global credit crunch when borrowing criteria have been tightened.
Third, the IMF recommends that governments increase wage flexibility so as to prevent a loss in competitiveness.
Fourth, financial supervision has to ensure that banks are well prepared for an economic downturn.
Marion Muehlberger, emerging market economist at Deutsche Bank in Frankfurt says that although there are signs that the authorities in the region are hearkening to the IMF’s call, more needs to be done. “While we see some of the proposed measures already being implemented,” she says, “governments have to show more effort in effectively engineering a soft landing. They have to step up efforts to tighten fiscal policy and limit real public wage growth, as these targets can be achieved most quickly.”
According to Mihails Rudiks, an analyst at Parex Asset Management in Riga, there have been positive developments on the macroeconomic front in the Baltics in recent months such as the slowdown in retail sales in Estonia and Latvia, which fell by 4% and 1.1% respectively in annual terms in the first quarter of this year.
Cooling down
Deutsche’s Muehlberger says that while there are encouraging indications that the overheating Baltic economies are cooling down – as measured by recent data releases such as retail sales, property transactions and car registration figures – much remains to be done.
“While those are all positive signs, the countries are clearly not out of the woods yet. To be sure that a soft landing is taking place, slower domestic demand has yet to feed through to the current account deficit, inflation, wages and external debt dynamics,” she says.
In terms of inflation, for example, Latvia with an annual rate of 16.7% now has the highest consumer price index in the entire 27-member European Union.
For rating agencies, it is the ballooning current deficits in the Baltics that have attracted most of the opprobrium and led to negative rating actions in recent months. For instance, London-based Fitch Ratings has slashed the outlooks on its ratings for Estonia, Latvia and Lithuania from stable to negative, principally as a result of the region’s growing trade imbalances.
“Current account deficits in the Baltic states have risen to levels that look disconcertingly stretched by current global or historical standards,” says Edward Parker, head of emerging Europe sovereigns at Fitch. “External deficits that were easy to fund in times of abundant liquidity and risk appetite may be harder to finance following the global credit shock, rendering countries more exposed to external financing risks.
“The negative outlooks reflect the heightened downside risk of an abrupt slowdown in capital inflows and a costly macroeconomic adjustment.”
Fitch estimates the 2007 current account deficits as being 25% of GDP in Latvia, 16% in Estonia and 13.7% in Lithuania – among the highest out of the 105 Fitch-rated sovereigns. “Double digit current account deficits are unusual, and many modern emerging market crises have broken at much lower levels,” says Parker.
For example, Thailand’s deficit peaked at 8.1% in 1996, the year before the Asian financial crisis struck, while Turkey’s stood at 4.9% in 2000, the year before the Turkish lira depreciated by 50%.
“There are valid grounds for believing that fast-growing transition countries can sustain quite high current account deficits. However, the history of financial crises suggests that it can be dangerous to think ‘It’s different this time’,” says Parker.
Fitch believes that with the credit crunch leading to a slowdown in global economic growth, it will be much harder for emerging European countries such as the Baltics to grow out of these deficits. For example, economic growth in the euro area, the key export market for the Baltics, is forecast to slow to 2.1% from 2.8% in 2007, thus trimming export growth potential.
The Euro issue
Widening current account deficits are not the only concern in the Baltics. Fitch says that the prospective timetable for euro adoption in the Baltic states has slipped in the past two years, with Estonia unlikely to join the euro zone before 2012 at the earliest, and Latvia and Lithuania possibly following suit a year later.
The rating agency says that membership of the euro zone for the Baltic states would materially reduce concerns over their current account deficits as it would render transfer and convertibility risk and the threat of balance of payments crises negligible, shelter participants from the risk of self-fulfilling currency crises, and reduce risks associated with foreign currency-related bank lending.
All three of the Baltic states have much higher than average foreign currency debt levels versus the rest of central and eastern Europe, with Estonia at 79%, Latvia at 86% and Lithuania at 57%.
The pace of credit expansion is another source of concern in the Baltics. During 2006-07 bank credit to the private sector grew by 41% in Estonia, 55% in Latvia and 40% in Lithuania, among the fastest growth rates of the sovereigns rated by Fitch.
While acknowledging that financial deepening is consistent with economic transition and convergence, Fitch says the speed of credit growth risks exacerbating macroeconomic imbalances and raises financial sector concerns about excessive optimism and over-borrowing, and a potential loosening of credit standards and poor-quality lending decisions that could sow the seeds for future non-performing loans.
The rapid expansion of bank lending in the Baltics has become a particularly contentious issue, given that the banking sectors in the region are largely in foreign hands.
Banking drama
While foreign ownership of banking sectors in emerging markets is widely seen as a net positive, introducing more sophisticated risk management and increasing local depositor confidence, Parker at Fitch says that there is a potential downside as well, given the acceleration in credit growth by foreign banks looking to use their financial muscle to secure a high market share.
“Such developments can exacerbate macro-financial risks – witness the large current account deficits – particularly if foreign banks focus on the consumer and property sectors, which do not add directly to export capacity,” he says.
The principal players in the unfolding banking drama in the Baltics have been Sweden’s Swedbank and SEB. Between them they have a 73% market share in Estonia, 55% in Lituania and 43% in Latvia, and the Baltic states represent a key element in the two banks’ profitability in recent years.
In recent months they have come under fierce criticism and have been accused of reckless lending and lobbying against restrictions on bank lending. The Swedish banks, however, say they have reined in lending sharply at the first signs of economic overheating, and point to the low level of non-performing loans in their portfolios – ranging between 0.3% and 0.4% – as evidence that they have behaved responsibly.
Fitch believes that a soft landing remains the most likely scenario in each of the Baltic countries whose ratings outlooks it has revised to negative. But the downside risk of a hard landing has increased. “A hard landing, particularly if it involved the abandonment of a currency peg, would entail significant economic costs and likely lead to rating downgrades,” says Parker.
He says that evidence that the Baltics are attaining soft landings – with declining current account deficits, rates of bank credit growth and external borrowing returning to more sustainable levels – could see a revision of the Baltic states’ ratings outlooks to stable.