After the fall
The Baltic boom turned to catastrophic bust as a massive credit contraction savaged domestic demand. Estonia, Latvia, Lithuania are now caught in a downward spiral as governments slash spending to keep their euro entry hopes alive – but at huge expense to economic and social stability
For years, capital poured into the Baltic economies, boosted by the region’s 2004 EU accession and pent-up domestic demand. Wages soared while almost daily new malls and apartments sprung up as business and consumers binged on cheap loans, fuelled by the surge in global credit.
Low interest rates on euro-denominated loans, soaring asset prices and, to a lesser extent, foreign direct investment helped the region register near double-digit average growth rates between 2004 and 2007 – the highest in Europe. In addition, per capita incomes increased by up to 50% from 2004 to January 2008.
But as early as 2006, fears had grown that credit-driven high growth rates had given rise to large and unsustainable current account deficits that could eventually force a hard landing for the region’s economies.
It’s ironic that a natural correction in domestic demand – in tandem with a long-anticipated cyclical global slowdown – would have been a relatively benign outcome.
Instead, the external financing crunch and sharp downward contraction in growth ended up being more dramatic than even the most bearish forecasts had predicted. The Baltic boom snowballed into a massive and disorderly bust, which also brought the region’s bumpy journey towards eurozone convergence to a grinding halt.
Since the world’s financial system crashed in the fourth quarter of 2008, credit in the Baltic states has dried up, investment has evaporated and government revenues have vanished.
Of all EU countries, the Baltics’ contraction will be the most dramatic this year. Fitch estimates that this year Latvia’s economy will contract 12%, while the Estonian and Lithuanian economies will shrink 10% on the back of shrinking domestic demand. Annual retail sales recorded in February in Estonia were down 19%, Latvia 27%, and Lithuania 21% while industrial output was also down 30%, 25% and 16% respectively, over the same period. And Latvia has already been forced to go cap in hand to the IMF: in December it secured a E7.5 billion bailout package.
The widespread anticipation of eurozone convergence led to a glut of issuance of euro-denominated credit for Baltic borrowers in recent years. Fixed currencies also lent creditors confidence in the stability of the region’s monetary policy.
Foreign currency-denominated loans (euros, Swiss francs and even yen) – mostly supplied by Nordic banks – accounted for 63% of loans to the non-bank private sector in Lithuania as of November 2008, according to Fitch.
Roughly 70% of all household debt in the Baltics is in foreign currency while non-financial foreign-currency corporate debt represented around 30% of all corporate liabilities in the middle of last year.
The region’s currencies are also subject to the Exchange Rate Mechanism II (ERMII) — the EU requirement to lock the national currency into a narrow exchange-rate band against the euro for at least two years before entering the common currency.
As a result, central banks lack independent monetary policy and the exchange rate cannot act as a shock absorber against an economic correction.
One consequence of this has been that the Baltics now face a so-called ‘internal devaluation’ where domestic wages and prices are being adjusted downwards, rather than an ‘external devaluation’ of the nominal exchange rate.
Businesses, households and consumers are experiencing a painful and abrupt downward adjustment in wages, nominal prices and a jump in foreign currency debt servicing costs. And according to Lithuania’s central bank governor, Reinoldijus Sarkinas, the pain has only just begun. “We are at the start of nominal adjustment” in prices, he tells Emerging Markets.
Hopes of a private sector-led economic recovery lie in the hands of Scandinavian bankers. During the 2002–07 boom, bank credit to homeowners rose at a staggering 60–80% a year. The Bank of International Settlements estimates that Swedish banks have a potential $80 billion exposure to the Baltics, representing 16% of Swedish GDP.
But loan defaults – primarily from real estate and construction – and high operating costs from Swedbank’s Baltic operations have already resulted in the bank losing $398 million in the first three months of this year.
Yet bank balance sheets have yet to be really tested, says Zsolt Darvas, researcher at European think-tank Bruegel. The Estonian finance ministry forecasts unemployment at 12.2% this year and 15.6% in 2010. As a result, loan defaults could skyrocket – testing the commitment of western lenders to maintain their regional operations to the limit.
Politics may also play a part. While the regional dominance of Scandinavian banks, such as SEB and Swedbank, has generally been seen as net benefit as it has reduced contingent liabilities for Baltic governments, there is a downside. Parent banks have been repatriating capital at the expense of their eastern European subsidiaries to shore up their balance sheets, with additional political pressure to concentrate on home markets.
Baltic governments are by and large unable to compensate for the capital loss, by either fiscal or monetary means. Moreover, foreign bank subsidiaries in the Baltics lack access to ECB (European Central Bank) liquidity facilities for their Baltic operations as they are outside the eurozone.
Fiscal policy in the Baltics has also been undermined: governments are being forced to slash spending as revenues contract, while fulfilling the so-called Maastricht criterion for euro adoption that mandates a 3% cap on the budget deficit.
But under current policies, a vicious cycle of “economic contraction, budget deficits, deflation, and political instability” could thwart euro membership indefinitely, says Philippe Aghion, economics professor at Harvard University.
The fundamental question remains: how to repay foreign-currency debt as the nominal value of regional currencies plummets and debt-servicing costs soar. “Whatever policies they choose, the Baltics face a severe recession,” says Ed Parker, chief emerging Europe sovereigns analyst at Fitch.
Partly as a result of this realization, there are growing calls for European authorities to grant the Baltic States fast track access to the eurozone to help pay down debts and boost regional liquidity. “Western Europe should be more lenient and allow for a counter-cyclical stimulus without it jeopardizing their chances to join the euro,” says Aghion at Harvard.
Lithuanian prime minister Andrius Kubilius said in an interview with Emerging Markets earlier this year: “Both the commission and ECB people should look more carefully on how to provide effective solidarity in trying to solve the problems of the transition members of the EU — members of the family — and all supportive measures, including the possibility of relaxing a bit of the Maastricht criteria [for eurozone convergence] should be considered.”
In March, recommendations were reportedly made by IMF staff that eastern European members should unilaterally adopt the euro – without formally entering the eurozone – as a way of addressing the currency mismatches. But European authorities insist Maastricht rules need to be followed through firmly and advocate fiscal austerity measures to stabilize regional economies in the medium term.
In a bind
Baltic leaders face a dilemma as waves of public protests against spending cuts sweep the region.
Most dramatically, in February Latvia’s coalition government collapsed amid discontent over the economic crisis. A new coalition government took office in March but is struggling to meet conditions on its E7.5 billion IMF bailout; the Fund delayed a E200 million transfer in March after authorities failed to implement budget cuts representing 5% of GDP.
Latvian finance minister Einars Repse believes a 7% deficit would be a “good basis for talks with the IMF – even a 40% cut in spending would only yield a deficit of 7.7% of GDP,” he claimed in April.
With municipal elections on June 6, the political costs of unpopular spending cuts are obvious. While rich countries embark on a massive Keynesian stimulus boost, the Baltics are forced into painful austerity under the current policy mix. The risk is growing of a self-reinforcing contraction where the budget slows the economy, which imposes further spending cuts, loan defaults, deflation, and so causes further economic contraction, says Aghion at Harvard.
This year will be crucial to the region’s eurozone entry prospects, says Oliver Weeks, emerging Europe economist at Morgan Stanley. Estonia’s new target date of January 2011, compared with its previous July 2010 target, is achievable given the country’s relatively stable price performance and greater economic competitiveness, he says.
In May 2006, the EU rejected Lithuania’s euro bid after the country missed its inflation target by a hair. Lithuania’s central bank governor, Reinoldijus Sarkinas, tells Emerging Markets: “the risks to euro adoption have now shifted towards the public finances.” As a result, Fitch predicts Latvia and Lithuania’s euro hopes have been derailed until 2013 or 2014.
With euro adoption now seemingly years off, currency devaluation – to boost exports and to help adjust after the crash – may now have more economic and political appeal. Weeks argues “the political commitment to quick euro entry means the distributional impact of choosing wage cuts and price deflation – rather than currency devaluation – will impose more of a burden on workers than corporates.”
Mainstream analysts still reject this option given the need to keep real exchange rates high to pay off euro-denominated debt; moreover, the currency peg still has significant popular support, garnered in the preceding years of economic stability.
But if it becomes clear that euro dreams have been relegated to the distant future, a shock currency devaluation in 2010 in Lithuania and Latvia – after the external aid agreement expires – “is now more probable” since the alternative is “an intolerably long period of aid, stagnation and wage cuts”, argues Weeks at Morgan Stanley.
New growth model
Baltic growth was driven for years by asset bubbles in high-value real estate and construction industries, as well as by rampant consumption. But the region will need to shift its economies towards export production instead of credit-driven growth.
With monetary policy still outsourced to Brussels, the region’s economies will need to rebalance through targeted fiscal policies and increased labour market flexibility. This would also help to address the structural weakness in the current account that has left the region disastrously exposed in the current crisis, argues Darvas at Bruegel.
Thankfully, the Baltics should be in a good position relative to its emerging market competitors: its “well-educated workforce, geographic proximity to western markets and good-quality institutions will serve the region well in years to come”, argues Parker at Fitch.
Unlike Asia and Latin America in the late 1990s, the Baltics have thinly traded currency markets and a low public debt. But like other disaster-prone regions in the past, the Baltics are characterized by inflexible exchange rates and a large stock of foreign debt.
The region’s historic makeover since the collapse of the Soviet Union is now showing unexpected cracks. But the real pain may have only just begun.