Ben Aris in Berlin -

The ratings agency Standard & Poor's issued a report in February warning that the Baltic states were overheating and headed towards a hard landing, but other economists in the region argue those fears are overblown.

Huge current account deficits – over 10% in Lithuania and Estonia, and over 20% in Latvia – have spooked investors, who fear a meltdown similar to that which swept East Asia in the 1990s.

"The large current account deficits give cause for alarm, but this a knee-jerk reaction. The three countries have successfully integrated into the EU and the banking system is more of a buffer [to a crisis] than a source of crisis," says Piere Cailleteau, chief international policy analyst at Moody's Investor Services. "The major risk is not of an Asian-style meltdown, but a repeat of the Portugal Syndrome - a number of years of economic stagnation, high unemployment and credit problems following accession to the EU."

Currency attacks

Latvia is in the worst shape and speculators attacked the currency at the start of the year in an attempt to force a devaluation. However, some economists argue the tiny republics have two things going for them that Asia did not: their small size and the fact of EU integration.

"There were attacks on the [Latvian] currency in the spring, but the foreign exchange market is shallow and the central bank has effective control of liquidity," says Hansbanka's chief economist Martins Kazaks. "As the foreign exchange market has effectively been closed, speculators can't borrow lats and it looks like these attacks have been beaten off."

The Latvian government has woken up to the problems and introduced an austerity package in March. Kazaks says that, rather unfairly, S&P released its report while the government was in the middle of working out its plan.

"High inflation and high credit growth is driving domestic demand, which has led to fast import growth, especially in Latvia and its ballooning current account gap," says Kazaks. "But the good thing is the government is aware of the problem and took action in March. There have been some administrative changes that should slow the growth of real estate prices by reducing the attractiveness of the investments and that will also affect credit demand. Some of these measures went into affect in April, but most of them only take force from the start of June."

Joining the EU will also have a significant stabilizing effect. Moody's acknowledged the problems of all three countries in March, but said that despite these problems the underlying economies were healthy and so it didn't intend to downgrade any of the countries.

"These problems look nasty on the surface, but they are all at root healthy economies," says Cailleteau. "However, we do expect them to have problems in the medium term."

End of the party

That is not to say that the problems aren't real. The danger is that corporate and personal debt is rising fast and at some point the banks will have to tighten access to credit, abruptly bringing the party to an end.

Dr. Ralf Wiegert, head of Eastern Europe at Global Insight, says: "It's rooted in the private sector and the real estate sector. The problem is that these markets are quasi-members of the Eurozone thanks to their currency boards that link the local currencies to the euro, which means they can borrow very cheaply in euros, which has lead to a boom on the real estate markets. It is possible to see a scenario where interest rates rise fast and then people will get into problems refinancing their loans and the bubble would burst."

However, the tiny size of the banking sectors and the dominance of Scandinavian owners is an effective counterbalance to the possibility of a meltdown led by a hike in interest rates.

"The three Baltic states have the advantage of being very small, which means that capital flight is restricted. Most of the inflows into these countries are coming through the Scandinavian banks that own a lot of the local banking system. It is in their interest to stabilise the situation and they won't run as a collapse would hurt their interests the most. This is in itself a stabilising influence," says Hansbanka's Kazaks.

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