3 years in the EU: Baltics struggle with Russia and too much of a good thing

By bne IntelliNews May 3, 2007

Paulius Kuncinas in Vilnius -

Lithuania, Latvia and Estonia are wrestling with two major problems they were probably not expecting to be dealing with three years after joining the EU: an increasingly assertive Russia and excessively fast economic growth.

Currently, the Russian issue is grabbing the headlines, with Tallinn locked in a bitter diplomatic row with Moscow over the removal of a Soviet-era monument. On Thursday, this fight took on an energy dimension, as most spats with Moscow do these days, as the state-owned Russian Railways suddenly halted oil deliveries to Estonian ports.

A symbol of what?

Lithuanian politicians, too, have gripes against Moscow over oil supplies. They accuse the Russian authorities of disrupting oil supplies to their oil refinery, Mazeikiu Nafta, which was sold last year to the Polish oil company PKN Orlen instead of Russia's Lukoil, much to the Kremlin's chagrin. A supposed "oil spill" on the pipeline that feeds the refinery shortly after the sale has since halted all Russian oil supplies.

And the Latvian oil terminal Ventspils Nafta hasn't received any Russian oil by pipeline since 2003, supposedly due to a lack of pipeline capacity. However, analysts note that at the time of the cut-off Moscow and Riga were locked in a row over Russian allegations that Latvia was mistreating its ethnic Russian minority.

Meanwhile, all three republics are highly critical of the proposed construction of a natural gas pipeline across the Baltic Sea from Russia to Germany, which will deprive these small countries of any clout they still have in regional energy politics. Together with Poland, the Baltic states are planning to build a new nuclear power plant in Lithuania.

While Russia remains a thorn in the Baltic states' collective side, as part of the EU and NATO the three have made unprecedented progress in establishing their economic and political independence. In many analysts' view, they are already punching well above their weight.

Open for business

Open and Westward looking, the Baltics were in many respects ahead of their Central and East European peers during the EU accession process, benefiting from a strict reform package, monetary stability and fiscal discipline.

Throughout the transition, Estonia used to set the pace, benefiting from an initial influx of capital and ideas, turning it into a shining example of how liberalization and a wholehearted embrace of market reforms can change a country's economic fortunes. But late-blossoming Latvia and Lithuania soon followed suit, privatizing swathes of their state-owned assets and quickly tapping into the benefits of capital inflows. This was most evident in the banking sector, which became the main driver of consumption and continues to fuel a property boom in all three republics.

"The Baltic Tigers", as they have been dubbed by the press, now enjoy GDP growth rates of well above 6% (in Latvia's case above 10%) per annum fuelled by rising consumption, construction, significant stimulus from EU reforms and a substantial injection of new funds.

Yet having got this far, the country's are now experiencing growth pains as their domestic markets mature.

In Latvia's case, it is the alarmingly wide current-account deficit, which reached 26.3% at the end of 2006. So far this has been a manageable problem because the total size of economy is quite small, analysts say.

In Lithuania, the most significant problem at the moment is a depletion of its labour force through migration to the EU countries. Theses migrants contribute much to Lithuania's domestic liquidity and purchasing power, but the exodus has pushed up local wages. Alfredas Baltrusaitis, project manager at a Lithuanian construction firm, says the cost of qualified builders has doubled in the last three years.

Some would like to import labour from countries such as Belarus and Ukraine, but cumbersome EU immigration laws prevent them from doing that legally.

Diversification challenge

Meanwhile, all three countries facing an uphill battle in absorbing the large amounts of EU funding. According to Giedrius Steponkus, chairman of Lithuania's Shareholders Association, the inflow from the EU over the next three years will account for some 10% of Lithuania's GDP per annum.

"There is a danger that all of it will go into one-sided infrastructure projects and not enough into improving the country's long-term competitiveness and economic added-value," Steponkus says.

A more fundamental dilemma comes from the competing goals of investing toward raising economic growth and the ultimate goal of joining the euro.

Lithuania is still feeling aggrieved at having missed an opportunity to become a member of the Eurozone in 2007 because its inflation was marginally higher than the 2.6% target set by the European Central Bank (ECB).

Steponkus says this "had a negative psychological impact on positive economic outlook and led to a revision of investment projects." However, it didn’t have any real impact on monetary stability, because all three Baltic states have currency boards. The question for Baltic politicians, though, is how they are going to maintain the fast growth, while keeping a lid on inflationary pressures, most recently stemming from a hike in energy prices.

Another common challenge facing all three republics is that their economic revival has come, to a large extent, on the back of a mortgage-led property boom and banking credits, which has fed into consumer demand.

This was fine when interest rates were low and the total volume of mortgages was also quite low. But with mortgage debt to GDP above 50% and interest rates rising, there is a growing concern that the property boom could lead to mounting bad debts.

Moreover, Steponkus argues, there is a concern that Lithuania, at least, is putting all of its eggs in one basket.

"Construction has become the main engine that is driving our economic growth these days thanks to mortgages and massive transfers from Lithuanians working abroad," he says. "Nonetheless, we need to diversify in order to enjoy sustainable future growth."

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