By Manfred Weidmann, UniCredit Group -

The growth rate of the Baltic economies in 2006 has been more than respectable: Latvia achieved a new record with 12% GDP growth year-on-year in the first six months, Estonia was just marginally behind with 11.7%, and one can't be disappointed at Lithuania's performance of 7.7% for the first nine months.

However, Estonia and Latvia are now increasingly facing the risk of overheating, with an average growth rate of 12% anticipated for 2006, whereas Lithuania's forecasted 2006 growth of 7.6% appears to be relatively stable and balanced.

The downside of this is that inflation has also accelerated in Estonia (2006 forecast 4.6%) and Lithuania (3.9%), while in Latvia it has remained at a high level (6.5%).

The outlook for these economies over the next two years, therefore, depends mainly on two factors: how the countries will react, first, to the capacity constraints that are now discernible, which will limit further growth potential; and second, to the further internal and external price trends determining inflation.

Given adequate adjustments in this regard, we expect – from an optimistic standpoint – some convergence in 2007-2008: growth could slow in Estonia and Latvia to approach the level of Lithuania. The same is true for Latvia with regard to its inflation.

Differences and similarities

The present differentials in GDP growth between the Baltic states can be attributed to a number of structural factors that have become apparent over the last few years.

First, Lithuania's economy is more evenly distributed at a regional level compared with Latvia, for example, where over 70% of its GDP is produced in Riga.

Second, in Lithuania a higher share of GDP is attributed to manufacturing, which to a certain extent acts as a stabilising factor. By contrast, services play a bigger role in Latvia and Estonia due to the fast-growing transport activities centred around their ports.

Looking at common trends in the Baltics this year, domestic demand based on investment and household spending has been, just as it was last year, the main driver of growth in all countries. Exports have also supported economic growth.

Growing employment and an accompanying rapid increase in wages and salaries have boosted consumer confidence to record levels, with households spending and borrowing more money. Whereas in Estonia and Lithuania the real estate markets have started to stabilise, the boom seems to be unbroken in Latvia.

Investment is being driven by companies' focus on increasing both production capacity and the efficiency of that production. The combination of favourable monetary conditions, available EU funds and sound financial data reported by many companies is also playing a supportive role.

Strong domestic demand, coupled with external factors like higher prices for imported natural gas, is responsible for the stronger-than-expected upsurge in prices of goods and services. The rise in domestic demand is also boosting imports, while foreign trade deficits are not improving despite strong export growth.

As a result, the "traditional" problem for emerging economies of relatively high current account imbalances will persist. We expect that in 2006 the current account deficit in Estonia and Lithuania, as a percentage of GDP, will be slightly above the level of the previous year, while in Latvia the difference with 2005 will be even more pronounced. In the ensuing years, the current account gap could gradually narrow if the import-boosting effect of domestic demand eases.

Going West

As outlined above, the shortages of production capacity and labour are crucial for the medium-term outlook of the Baltic states, not only for their growth but also for the price and wage factors that contribute to inflation.

Labour market bottlenecks have been exacerbated by the sizeable migration of workers in search of higher incomes since EU accession. The outflows are strongest in Lithuania (3.3%) and Latvia (2.4%), with Estonia following further behind (1.0%). A recently published World Bank report called on Baltic governments to manage labour migration more actively. The report recommends measures such as reducing high labour taxes and in some cases enhancing social benefits to encourage workers to stay at home. And it suggests even more liberal laws in respect to the import of labour from further east.

As inflation has persisted at the high level of previous years, the Baltic countries' schedules for the adoption of the euro have become obsolete.

Latvia was planning to adopt the euro in 2008, Estonia and Lithuania in 2007. New target dates haven't been officially set and unofficial statements range from "as soon as possible" for Estonia, 2010 for Lithuania and tentatively 2010-2011 for Latvia.

Latvia's finance minister recently favoured a simultaneous switch to the euro by all three countries. Whether his counterparts share this view will become apparent at a meeting of Baltic finance ministers due late this year or in early 2007.

Notwithstanding these delays, the currency boards of the Estonian kroon and the Lithuanian litas, and the tight peg of the Latvian lat to the euro will provide a stable monetary environment. Local interest rates are expected to follow euro interest rates, as was the case most recently when the Bank of Latvia raised its policy rate by 50 basis points following the hike by the ECB.

However, there is also an adverse effect from the existing currency systems: in the context of an inflation rate that is higher than that of the Eurozone, the Baltic states' competitiveness might weaken through increases in real exchange rates.

With shares of between roughly two-thirds for Estonia and Lithuania, and 75% for Latvia, the EU is the major export market for the Baltic states. But this trend may force Baltic exporters to adjust existing technological structures more quickly towards higher levels of value added, which is necessary anyhow in the longer term.

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