The recent data from the USA, Japan and the big countries in the Eurozone have indicated that these economies are recovering from the downturn unleashed by the global financial crisis. Data for second quarter growth in the three Baltic countries has also been released within the last week or so, but the overall picture is still mixed. This blog piece provides a bit of background information which is sometimes missing in the newspaper commentaries.
To start with the raw numbers, from the second quarter 2008 to the second quarter 2009 the economy contracted by 16.6% in Estonia, 19.6% in Latvia and 22.4% in Lithuania. These numbers follow a similarly dismal first quarter and imply that all three economies now qualify for the dismal “depression” label (see Figure 1).
Needless to say unemployment has increased as lower production volumes have made firms shed workers. Eurostat estimates that the unemployment rate in June 2009 was 17.0% in Estonia, 17.2% in Latvia and 15.8% in Lithuania (although national authorities report unemployment rates that are a couple of %-points lower).
The severe downturns come on the back of years of strong growth since the Russian crisis in 1998-99. Until mid-2007 the annual growth rates hovered within the interval 5-10%, implying a rapid closure of the income gap towards the EU15 countries (albeit from a low starting point). Figure 2 shows an index of the GDP level with the average value for 2000 set equal to 100. The downturn has set the countries back to their 2004 income levels, i.e. to the levels around the time of entry to the European Union.
The overall economic development has been remarkably similar in the three countries in spite of many structural and policy differences across the countries. Estonia has traditionally had the highest income level with Lithuania and Latvia trailing, respectively, 10 and 20 % behind. The trading partners as well as the industry structure differ markedly. Estonia is more open, ranks high on indices of free market economies and has generally pursued the most prudent fiscal policies. All three countries have pegged exchange rates, but in the beginning of 2002 Lithuania switched the peg from the dollar to the euro which subsequently resulted in a substantial real appreciation. In spite of all these differences, the relative economic position of the three countries has not changed in any noticeable way over almost 15 years.
The causes of the depression are relatively easy to identify. Data shows that the downturn is concentrated in three sectors, namely industrial production, construction and retail trade. Figure 3 shows the development of industrial production in the Baltic countries and, for comparison, also in Sweden and Finland. Given the limited size of the Baltic economies, the industrial production is primarily exported. The global demand compression has hit the Baltic countries in line with the experiences in neighbouring small countries Sweden and Finland. (It is remarkable that although Sweden has seen its currency depreciate markedly against the euro, its industrial production mirrors the Finnish case in spite of Finland using the euro. The exchange rate developments do not seem to make much of a difference in the current situation of a general demand collapse.)
Returning to Figure 1, it may, at first sight, be surprising that the GDP fall in 2009 in Lithuania has been larger than in the two other countries, including in Latvia which has experienced a severe financial crisis. Part of the answer is that industrial production constitutes a much larger share of GDP in Lithuania (approx. 25%) than in Estonia (20%) and Latvia (15%). Thus, the collapse of industrial production has a disproportionate effect on overall GDP in Lithuania.
The construction and retail sales sectors have also seen dramatic value-added falls. The main factor behind the contraction in these two non-traded sectors is the retrenchment of credit available to both enterprises and households.
All three countries saw rapid credit growth from around 2003 when membership of the European Union became virtually certain. The EU confidence shock encouraged people in the Baltic countries to borrow more to buy the cherished hallmarks of prosperity, namely real property, cars and foreign travel. The EU shock also encouraged increased inflows of foreign capital. The greater demand and supply for capital was intermediated by the banking sector, whose exposure increased in the process. In the statistics the capital inflow showed up in the form of gigantic current account deficits. In Lithuania the 2002 re-pegging of the currency meant that the Lithuanian economy never overheated to the same extent as in Estonia and Latvia and the current account deficit remained smaller than in the other countries. (See Figure 4.)
In the second half of 2007 it became clear that the private debt stock in Estonia and Latvia had reached its peak and the capital inflow started falling, reflecting itself in lower current account deficits. In Lithuania the credit slowdown took place half a year later due to the lower debt stock of households and firms. In the summer 2008 the typical assessment was that the debt driven expansions had run its course and it was time to consolidate exposures. This benign scenario was shattered by the global financial crisis.
Latvia has been most severely hit. In the fall 2009 the Latvian government had to bail out Parex bank, the second biggest bank, when the bank experienced problems rolling over its syndicated loans. The uncertainty emanating from the bailout in combination with the “flight to safety” after Lehman Brothers went belly up meant that the government lost access to credit on commercial terms. The government had to turn to the IMF, which put together a rescue package amounting to a whopping 7.5 billion euro.
In all three countries foreign capital inflows essentially dried out during the last quarter of 2008 and forced a drastic adjustment. Credit volumes fall in both real and nominal terms, which have led to lower demand for real estate, cars and many other products. All three countries have attained positive current balances in the first half of 2009, stemming from trade balance surpluses due to import having contracted even more than export.
So where are the Baltic economies heading? All three governments have repeated their commitment to maintain the hard pegs. They also pursue tight fiscal policies to avoid that the budget deficits explode in lieu of collapsing tax revenues. (I will later return with a blog piece on the fiscal policies in the Baltics.) In other words, economic policies do not provide any stimulus in the current situation. The main perception is that the depression is bottoming out these days as the fall in quarter-on-quarter GDP has been declining. Growth may then turn positive in the fourth quarter 2009 or early next year.
The scenario for return to growth rests on economic activity picking up in the western trading partners with increased export from the Baltics as the result. Statistics for the first quarter of 2009 suggest that the nominal wage growth has decelerated markedly. The press in the Baltics is also full of stories of workers being forced to accept nominal wage cuts, but there is still not substantial data evidence to suggest that this a widespread phenomenon. Finally, a normalisation of the situation in financial markets might also imply that some credit will start flowing to the Baltics again. The Baltic countries have learned how dependent they are on developments in the world economy. Indeed, an early recovery in the Baltic economies requires that the recent positive news from the USA, Japan and Eurozone are sustained in the second half of 2009. Whether this is a realistic assumption is anyone’s guess.