Where are the Baltic Tigers heading?

The Baltic countries have been bestowed with several nicknames to portray the spectacular economic success of the region since the mid-1990s. The weekly The Economist introduced the term ‘Lynx economies’ and others have talked about a ‘Baltic Miracle’, but the ‘Baltic Tigers’ is probably the most lasting idiom. In all cases, the moniker express the great surprise of the Baltic countries doing so well in economic terms after the difficult transition in the beginning of the 1990s. The question is now whether the impressive macroeconomic performance can continue or there are difficult times ahead for the countries?

The three Baltic countries regained their independence from the Soviet Union in August 1991, facing a multitude of problems. Large parts of the administration had to be built from scratch, inflation reached hyperinflationary levels, and trade with the former East Bloc countries was severely disrupted. The period until the mid-1990s saw a very large decline in GDP in all three countries, although the magnitude of the declines is still disputed. The subsequent boom is, however, not in doubt, and annual growth rates in the double digit range have not been uncommon. The figure below shows annual GDP growth on a quarterly basis from the first quarter of 1995 to the fourth quarter of 2007.

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The figure clearly shows the very high trend growth in the Baltic countries, only interrupted by the downturn in 1999 as fallout from the Russian crisis. Given the low initial income levels, part of the impressive growth performance can probably be explained by ‘catch up’, where import of technology and organisational knowledge speed up growth. In 2006, the purchasing power adjusted GDP per capita in the Baltic countries still amount to approximately 50-60% of the EU27 average.

The figure also points to a spurt of growth (especially in Estonia and Latvia) starting in 2004, i.e. around the time when the Baltic countries joined the European Union. The magnitude of the subsequent boom has surprised many observers and policymakers in the three countries. In hindsight the growth spurt may be less surprising, since the countries received very large capital inflows as reflected in large current account deficits. (Scandinavian banks in particular have expanded lending to their Baltic subsidiaries.) The capital inflow led to lower interest rates and make credit more readily available, which then stimulated domestic consumption and investment.

It is clear that double digit growth rates and current account deficits in the range of 10-25% of GDP cannot be sustained in the longer term. The question is then how the adjustment will take place. Two scenarios are indicated. A ‘soft landing’ scenario foresees a gradual reduction of lending from abroad and a subsequent cooling of the Baltic economies. A ‘hard landing’ scenario amounts to a crisis scenario, where a shift in expectations leads to capital flight, pressure on the exchange rates and a rapid contraction of credit. The result will be significantly reduced domestic demand and an economic downturn. The likelihood of each scenario is difficult to assess. A number of investment banks and other analysts have drawn up a gloomy picture of future events in the Baltics. Against this stands the fact that all three countries have stable fixed exchange rate regimes, which have proved resilient previously, e.g. during the Russian crisis. Furthermore, the countries have already implemented a number of measures to cool down the economies, including fiscal measures and higher reserve requirements on the bank.

Most importantly, however, may be the strains in world financial markets, which started with the subprime crisis in the US more than half a year ago. The financial crisis has led banks and other financial institutions to reduce lending, implying substantially tighter borrowing conditions in the Baltic countries. Meanwhile, the crisis has meant that short-term interest rates have been lowered instead of increased as widely expected a year ago. The positive side effect of this is that indebted borrowers in Estonia, Latvia and Lithuania will not face larger debt servicing payments, which again may reduce the likelihood of widespread bankruptcies. The global financial setback may thus have led to exactly the form of financial restraint that the overheating Baltic countries need.

Preliminary data for the fourth quarter show a marked slowdown in all three countries and in particular in Estonia and Latvia, the two countries most prone to overheating. Meanwhile the current account deficits appear to be heading in the right direction. Overall, it seems as if the Baltic countries can breathe a bit freer; the big financial meltdown is unlikely to materialise. Instead, the countries likely face a period of slower growth and expansion of the export sector. I should hope is that such a cooling will also slow down prices increases as the Baltic countries currently have an inflation problem; this is a point I will return to at a later stage.

 

Readers interested in more on the economic developments in the Baltic countries may wish to read my recent overview article ”Economic Development in the Baltic States: Success and New Challenges”, published in Monetary Review (National bank of Denmark), no. 4, 2007, pp. 79-96: http://www.nationalbanken.dk/C1256BE9004F6416/side/3CD2C815D21B921FC12573D4004DA5E4/$file/mon_4qtr07.pdf.

4 Responses to "Where are the Baltic Tigers heading?"

  1. Mary Stokes   February 13, 2008 at 6:53 am

    Thank you for your post! You appear to be more optimistic than many economists, such as those at Danske Bank, that the Baltics can avoid a hard landing. My question for you is whether you believe fixed exchange rates contributed to overheating in the Baltics? You point out the resiliency of their fixed exchange rates and note in your article that they turned to this type of exchange rate regime to try to contain inflation. But is it now time for them to move away from their pegs? This would give them more room to deal with overheating concerns, like inflation, without having fiscal policy – a rather blunt tool – as their only resort. On the other hand, it could potentially affect Baltic residents, earning in local currency, that have taken out fx-loans.Also, this bout of overheating seems to have pushed back euro adoption for the Baltics. Fitch believes Latvia’s ‘deteriorating price stability’ will delay its entry until 2013. It will be interesting to see how the pushing back of euro adoption impacts capital flows into the region. Any thoughts on what we might see?

  2. Karsten Staehr   February 13, 2008 at 8:05 am

    To Mary Stokes: Thank you for your comments and questions. Yes, indeed I believe that the risk of overheating and financial meltdown in the Baltics is rapidly receding. This is based on inter alia the most recent on GDP growth, current accounts and lending volume. Danske Bank has occasionally been very bearish, but then again, they rely on broad media coverage and you do not get that if you provide a balanced view.I guess the fixed exchange rates (currency boards for Estonia and Lithuania and a very tight peg for Latvia) may have contributed to the overheating as the capital inflows have not been accompanied by appreciating exchange rates. Then again, having flexible exchange rates in very small and very open economies is often a mixed blessing, as all kinds of shocks affect the exchange rate so that in practice the exchange rate does not have the stabilising role as envisaged in the (simple) textbook models.I think the Baltics should stick to their fixed exchange rate systems until they are one day admitted to the EMU. First, I think more flexible exchange rates could lead to nasty experiences, cf. paragraph above. Second, people here are so used to fixed exchange rates that more flexible systems would lead to much confusion. (For instance, I have my current account in an Estonian bank and “inside” this one account I have both Estonian kroons and euros and I can freely more cash around between the two subaccounts. With floating exchange rates, such accounts would probably have to be abolished.) Third, more than half of all loans are denominated in euros, while the rest is in local currency. More flexible exchange rates would lead to (unanticipated) wealth redistribution. Indeed, the relatively high inflation (10% or more) rules out membership of the EMU in the following years. I hope that the delay of EMU membership may reduce capital inflows a bit – this is exactly what the Baltic countries need. Notice, however, that inflation has increased fast, so it may also recede fast. Membership is not right around the corner, but is still a realistic goal within 3-5 years. I will devote a future blog piece to the inflation problems of the Baltic countries and their prospects of EMU membership.

  3. Mary Stokes   February 13, 2008 at 1:28 pm

    Thanks for your response! Your arguments in favor of maintaining fixed exchange rates make a lot of sense to me. I look forward to reading your future blog on the Baltics’ EMU membership prospects.

  4. Guest   February 21, 2008 at 5:59 am

    Hej KarstenJeg kunne ikke finde en e-mail-adresse – derfor får du en “kommentar” ad denne vej. Det kommer til at se dumt på bloggen, så slet mig endelig.Du kan nok huske mig: Jeg var ung fuldmægtig, da du var student hos Poul Uffe i ADAM-gruppen – dengang du lavede lønrelationen (som viste sig robust mange år frem). Vi brugte megen tid på at koble det nye AREMOS, med de gamle data på UNI-C.Du er nu professor i Thalin, ser det ud til! Ak ja, det kan ske for selv den bedste.Jeg er nu forsker i DTU Transport (tidligere Danmarks TransportForskning), og lavede sidste år en opgave om olieforsyningssikkerhed for Transportministeriet.Vi foreslog at tage hensyn til usikkerheden på olieprisen ved at inkludere en risikopræmie, når man laver CB-analyser. En del af inspirationen kom fra din “tool box”-rapport fra IMV – afsnittet om “certainty equvalence”. Vi lavede nogle konkrete regneeksempler på hvad en risikompræmie kunne betyde for nogle forenklede CB-analyser af tænkte projekter såsom bio-fuels-biler og flex-fuel-biler, og vi prøvede at tage høje både for olieprisens egen varians og for evt. covarians ml. oliepris og andre brændstoffer samt olieprisen og BNP.Vi anvendte værdier fra litteraturen for enkeltpersoners “relative risk aversion” til at værdisætte risikoen.Så vidt jeg ved anvender man ikke sådan noget i praksis i landene omkring os (jeg har set et studie, hvor man sammenligner CB-analyser i en række europæiske lande, og det ser ud til at risiko kun indrages verbalt).Nu skal jeg prøve at lave en videnskabelig artikel om arbejdet, og vil gerne vide, om du har kendskab til nogen, som rent faktisk har anvendt det her i CB-analyser? Du henviser til Walls (2004), som jeg har kigget i, men det ser ud til være mere til private investeringer. Og Walls henviser til noget undervisningsmateriale fra 1968. Eller måske kender du andre relevante arbejder?Håber ellers at du trivesMvh ThomasThomas Christian JensenResearcher DTU TransportDepartment of Transport Bygningstorvet 116 VestDK-2800 Kgs. LyngbyDenmarkTlf.: +45 45 25 65 00Dir.: +45 45 25 65 44