COMMENT: Booming Baltics - but what's next?

By bne IntelliNews June 19, 2007

Marcus Svedberg of East Capital -

It is hard not to notice the boom in the Baltics. Estonia and Latvia were the two fastest growing economies in the enlarged EU last year – GDP grew by 11.4% and 11.9%, respectively – and Latvia was among the top five.

The primary economic driver is domestic demand and the consumption and investment boom is noticeable wherever one turns in Tallinn, Riga and Vilnius.

The fourth annual East Capital Summit – Baltic States in Tallinn on May 29-31 focused on this extraordinary state of affairs, but also looked into the future. The economic boom – which according to Estonian President Toomas Hendrik Ilves was due to good policies and the positive shock offered by EU accession – has resulted in fears of overheating, with high inflation and widening current account deficits.

Overheating – a pleasant problem?

Overheating seems like a pleasant problem, as it basically means that countries are growing too rapidly and have external imbalances and capacity constraints. Overheating is about growing too much, too quickly.

The main problem with overheating is that it might lead to a hard landing. Some analysts and economists are increasingly worried that the Baltic states in general, and Latvia in particular, are in for a hard landing. The external imbalances, very rapid credit growth, and increasing wages and prices, they argue, are not sustainable and will lead to a sharp and prolonged correction.

Other analysts are arguing that although a correction is inevitable, there will be more of a soft landing, especially for Lithuania and Estonia, where growth will slow down to more normal levels for a couple of years.

Yet another group of analysts argues that countries like Estonia, which has consistently pursued good liberal economic policies, creating a superior economic system, can continue to grow with external imbalances for years. The mainstream concerns about inflation and current account deficits are based on a flawed understanding of transition economics, according to these analysts.

Soft landing most likely

All these views were represented at the East Capital Summit, which stimulated a lively debate on the future prospects for the Baltics. In our view, the most likely scenario is a soft landing, although we are concerned about Latvia and the risk of psychological contagion to the other markets.

One problem is that even if the optimists are right, it may still go wrong if the market interprets the situation according to the pessimists. Moreover, even if only Latvia qualifies for a hard landing and the actual links to the other Baltic states are weak, it may nevertheless spread as the rest of the world tends to view these markets as one.

Marcus Svedberg is Chief Economist at East Capital

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