By Mike Halls
Talk of a ‘Baltic Spring’ – a renaissance for the region – a few years ago was based on a period
Situation grim, outlook even grimmer. That seems to be the general view on the Baltic economies of Estonia, Latvia and Lithuania for the next year and beyond. Growth is likely to elude the region for the foreseeable future.
The credit crunch and related turmoil on the world’s financial markets suggest that large swathes of the world are about to enter a sharp, and possibly sustained, downturn. What’s more, such a slump in the European Union and Russia – the two destinations where these countries generate most of their export revenues – could depress economic growth even further.
But what’s perhaps the most galling for the region is that, until recently, it comprised some of the most successful economies in the European Union, as a quick glace at their growth rates attests.
Sand banks
Yet that growth, it seems, was built on sand. In just two years, Estonia and Latvia have moved from being the fastest growing economies in the European Union to being among the worst: this summer both moved into full-blown recession, i.e. two quarters of negative growth.
Estonia’s GDP contracted 0.8% q/q in the second quarter of this year and 0.9% q/q in the first. Latvia’s economy also shrank, falling 0.2% in the second quarter and 0.3% in the first. There is much worse to come.
Lithuania, the other growth star in the Baltic firmament some three years ago, is probably also in recession if you strip out the exceptional item – an oil refinery fire in 2006. Given the refinery’s contribution to the Lithuanian economy, this flattened the basis for GDP growth until it came back on-stream at the end of 2007, so boosting the nominal GDP figures for the year.
The present financial turmoil also hurts the Baltic republics’ ability to access international debt markets to alleviate some of the short-term pain. This is largely private-sector debt, so talk of sovereign default is off the mark. Nevertheless the sums are large – especially when put into the context of each nation’s domestic output. Latvia has $26.2 billion in debt maturing this year, equivalent to 79% of GDP. For Estonia this is $18.4 billion, or 77% of GDP, and for Lithuania $25 billion, or 53% of GDP.
Put into context, the Baltics’ problem is only part of a larger issue. A total of $940 billion of foreign and local currency debt, which includes bonds, loans and deposits, needs to be refinanced in eastern Europe this year, according to ratings agency Standard & Poor’s.
The boom/bust events in the Baltics have their parallels elsewhere across eastern and central Europe: “Developments in the Baltics should also set alarm bells ringing in Bulgaria, which has many of the same imbalances as well as a fixed exchange rate,” says Neil Shearing, emerging Europe economist at Capital Economics, a London-based consultancy. Other analysts say Hungary and Romania are in a similar position.
Membership fee
The problem for all three Baltic nations is, perversely, membership of the European Union, of which they became members in 2004.
One of the consequences of EU membership was the rush of investment money into the countries and, in particular, the creation of a speculative property bubble ahead of their accession. With a more difficult financial environment in place since the start of the year, foreign investors have pulled back, and the first reversals in property prices started to gather momentum.
This summer, according to international estate agents Knight Frank, property prices have dropped by 10% in Tallinn, the capital of Estonia, and 20% in Riga, Latvia. Standard & Poor’s says that prices in Vilnius, Lithuania are now flattening and that residential property transactions in the first quarter have fallen by 20%.
Construction sector confidence has slumped, and house price expectations are at record lows. In Estonia, where construction accounts for roughly 20% of GDP, activity looks set to fall by 10–15%. This alone would be enough to take roughly 2% off growth. “Arguably the more important factor is a sharp drop in private consumption,” says Shearing at Capital Economics. “Of course, this is linked to the property slump, since consumers can no longer rely on booming house prices to do the work of old-fashioned savings,” he says. Consumer confidence has slumped, and retail sales, which account for roughly 25% of GDP across the region, contracted by 1% year-on-year in Latvia in the first quarter.
Long way to fall
Dealing with the associated current account deficits is the problem facing all three countries. Unfortunately, the rising stars of yesteryear are going to take time before they regain any of their former lustre: a quick recovery is unlikely. All three economies need to rebalance away from domestic demand and towards exports. Given that boosting exports, in the words of one analyst, is “quite simply not going to happen”, the only way is to restore export competitiveness and cut imports.
There is little wriggle room available from adjustments to their foreign exchange position: all three countries operate currency boards; they cannot rely on a fall in the nominal exchange rate to restore competitiveness and boost net exports. Instead, the real exchange rate must adjust via domestic prices.
But if the situation deteriorates, could the countries be forced to scrap their currency boards and devalue? “There’s a low probability of a forced devaluation in each of the three Baltic States, barring either a highly unlikely withdrawal of credit lines by the largest foreign commercial banks or a sharp loss of domestic confidence in sovereign currencies,” says Eileen Zhang, an analyst at Standard & Poor’s. “But even in these two stress cases, all three have sufficient reserves to buy back their currency in circulation and unilaterally adopt the euro.”
So for all three, the only cure appears to be to grin and bear it. “With inflation set to remain high for some time, the adjustment is likely to be long and painful,” says Shearing. “We therefore expect growth to remain below potential until the end of the decade.”