Ben Aris in Berlin -

The three "Baltic Tigers" have got a thorn in their collective foot. Fast out of the gate with reforms and growth, the tiny states on the northern border of the EU have all become victims of their own success. Economists warn their economies are overheating and the ratings agencies marked down their ratings because of the "visible danger of a hard landing."

Latvia, Lithuania and Estonia all have current account deficits equal to or higher than 10% of GDP, but analysts say a violent sell-off like that which Asia suffered in 1997 is unlikely since these countries have joined the EU. Instead, Moody's Investors Service warns they face the "Portuguese Syndrome" - a period of rapid growth in the run-up to accession, followed by decades of stagnation as they go through a long process of restoring competitiveness through painful structural reforms aimed at boosting productivity.

Small and nimble, the Baltic states in many respects overtook their Central European peers while trying to clear the hurdles imposed by Brussels during the accession process, which was completed three years ago.

There were real economic benefits to be earned from reform that was part of the package of laws each country had to adopt to joint the club. But the real benefit of the process was the political discipline the process imposed on governments across the region - there was no shirking the reforms if the tiny northern states wanted entry and this put some steel into the government's resolve to push through often painful reforms.

As the smallest and most progressive of the trio, Estonia used to set the pace. It benefited from committed leaders under former president Lennart Meri, and the initial influx of capital and ideas primed the pump for growth. After whizzing ahead, Estonia became a shining example of how liberalisation and a wholehearted embrace of market reforms can change a country's economic fortunes. Latvia and Lithuania were slower off the mark, but learnt the Estonian lessons well and soon followed suit, privatizing swathes of their state-owned assets and quickly tapping into the benefits of capital inflows.

The rapid gains made by Estonia also catalysed the process in Lithuania and Latvia; investors who had done well in Estonia poured money into the other two to make rapid progress a self-fulfilling promise.

The process was most evident in the banking sector and the free availability of credit started a virtuous circle of spending and investment. Strong investment, related to construction and the addition of new production capacity, is one of the main drivers of growth throughout the region. Investment continues to be supported by extremely good results in terms of corporate profitability, generally high market liquidity and improved access to external financing; this is feeding through into consumer spending, which supports the whole cycle.

But it seems the cycle is now running out of control and the governments of these Baltic states are trying to put on the breaks. Having got this far, the countries are now experiencing growth pains as their domestic markets mature. They have become victims of their own success.

"Estonia and Latvia continue to show signals of economic overheating, while the national saving gap is recognized as a structural phenomenon in all of the three Baltic's," say analysts at UniCredit's New Europe Research Network.

Estonia running too hot

The Estonian economy is running hot after it grew 11.4% in 2006 and still shows no sign of slowing down. Employment is at a record high, driving up prices and the current account deficit is widening. The new government of Prime Minister Andrus Ansip that was elected in March 2005 will keep state finances in a sound condition, say analysts, but will do little to end the strong growth. Cooling could thus come only from reduced capital inflows and slower expansion of credit, neither of which is expected to happen in the short term.

Analysts worry this heated economy faces a "hard landing," as corporate and personal debt is rising fast. And at some point the banks will have to tighten access to credit and abruptly bring the party to an end.

The plus is the large FDI inflows of €1.3bn in 2006 and about €1.6bn of international borrowing by domestic banks means that the government can easily cover the current account deficit that widened from €1.6bn in 2005 to €2.1bn at the end of 2006, equivalent to two months of imports, or 14.8% of GDP.

"The current account deficit will widen further this year as domestic demand is not levelling off and the [national currency] the kroon continues to appreciate in real terms," UniCredit said.

The Ansip government's policies are pro-business, including more of the tax cuts that have made Estonia such an attractive investment destination in the first place. However, the government is also cutting social spending and will manage to maintain a fiscal surplus that underpins the health of the economy, although the surplus is expected to dwindle slowly from here.

Despite the tightening macroeconomic situation, the results of the first quarter show that both industrial production and consumer spending continue to roar ahead.

Lativa overheating

Latvia is in even more trouble. The economy is clearly already overheating, say analysts, and the macroeconomic imbalances are getting out of hand. The economy grew by 11.7% year-on-year in the fourth quarter of 2006, fuelled by strong industrial growth and an unprecedented rise in employment, bringing with it rapidly rising wages and double-digit credit growth. The whole country has gone on a massive spending spree that has fuelled both public and private consumption, which was up by a whopping 24% and 9% respectively in the same period.

This is most clearly seen in 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. But some big investment projects on the docket for this year mean the current account will remain under pressure, mostly financed by international borrowing that has taken the country's external debt over 100% of GDP this year. However, FDI more than doubled last year to €900m, or 8.1% of GDP, which ameliorates the imbalances somewhat.

The tightening labour market coupled with the spike in spending has resulted in worryingly high inflation, which continued to unnerve the markets, say economists, reaching a high of 8.5% year-on-year in March. Prices have been constantly rising since October thanks to rising wages and energy tariffs, a problem that has been made worse by a weakening of the national currency, the lat, since the second half of February.

A soft landing is still possible, but the government has to bite the bullet and go back to imposing a tighter reign on the economy - something politicians are reluctant to do following access because of what the EBRD has dubbed post-accession "reform fatigue."

The government acted in March when it endorsed an inflation control plan that is supposed to, among other things, cool the credit growth and so (hopefully) take the edge of the fast growth. The goal is to switch from simple growth to improving productivity, but hikes in gas prices mean the rate will stubbornly remain over 7% this year, say economists.

"We expect these measures to start having some affect on inflation only from the second half of the year. The planned rise in natural gas tariffs by 33% on average from the beginning of May and the seasonal price rise of foodstuffs, will contribute to keeping inflation above 8% in the next three months," say analysts at Unicredit. "Inflation is expected to move below risk-free levels only from 2010."

The macroeconomic imbalances are already having a destabilising effect on the economy and there were rumours of a possible devaluation of the lat in February that led ratings agency Standard & Poor's to downgrade the country's currency rating from stable to negative because of "visible hard landing risks." Fitch Ratings too said it was, "particularly concerned by high credit growth where credit-to-GDP has already reached a high level."

However, not all the agencies agree. Moody's acknowledged the problems of all three countries in March, but said that despite the problems, the underlying economies were healthy and so didn't intend to downgrade any of the countries.

"Although the short-term economic outlook for these countries has deteriorated, the fundamental creditworthiness of the governments remains strong... Stress testing indicates that the governments of the Baltic's can all absorb significant economic shocks without causing major strain to their balance sheets," the agency said in a report.

Lithuanian clouds have silver lining

In Lithuania, the recent problems with Russia have had a silver lining; slower growth means the economic imbalances are not as pronounced and so the problems they need to fix are not as severe.

Last year's growth was a record 7.5%, but Lithuania is still the slowpoke of the region. Growth would have been higher, except the oil row with Russia lead to a dramatic slowdown in the second half of the year.

Annual inflation reached 4.6% in March, which was the highest year-on-year increase since the 1990s, but still less than its peers are suffering. And the trade deficit has been growing, fuelling the current account deficit which reached 10.8% of GDP in 2006, up from 7.2% in 2005. However, the government has nearly balanced the budget and is running prudent policies. The budget deficit is a very modest 0.3% of GDP, while things like public debt have been falling and reached 18.2% of GDP in March.

If these problems weren't enough, Vilnius has also clashed with Moscow over oil supplies. Lithuania accused the Russian authorities of disrupting pipeline 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.

The oil spat with Russia has been a boon. Despite the short-term problems it brought, economists are predicting the country should go back to strong growth in the second half of this year and ironically the current problems will have a positive effect on the economy going forward.

"In recent months, a 'soft landing' scenario appears to have started to materialize for the Lithuanian economy," say analyst at Unicredit. "Compared with the other two Baltic states, the imbalances in the Lithuanian economy appear pronounced but less dramatic: growth, inflation and the current account gap are lower, and wages are growing at lower rates."

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