Mike Collier in Riga -

The attention of overseas economy-watchers may be focused on the Baltic states' battle with inflation, but local analysts have identified a different and potentially much more serious imbalance - a worsening labour shortage.

A direct consequence of joining the EU in 2004 is mucking up the Baltic labour market. Balts welcomed the freedom to travel and work abroad with relish and thousands have packed their bags for Western Europe where their skills in the construction, agricultural and service sectors are in demand and wages are higher.

Consequently, a new "invasion" of Ukrainians, Belarussians, Bulgarians, Central Asians and Russians is arriving to fill the vacancies left behind as the Baltic economies continue to quickly expand.

The outflow is particularly troubling for the small Baltic states, whose populations aren't much larger than those of some large cities in Western Europe. Latvia's population of 2.5m is roughly equivalent to Greater Manchester's.

A Latvian government estimate noted, with an air of resignation, that only around a third of those working abroad are expected to return to their homeland. Ministers quoted a figure of 20,000 returnees from 60,000 émigrés, but that figure is itself a serious underestimate of the number of workers abroad. It includes only fully registered, taxpaying Latvians in the UK and Ireland. A report by SEB Unibanka estimates the figure to be more like 100,000.

Migration has reduced competition for jobs to such an extent that employers are resorting to desperate measures to fill vacancies. In Lithuania, for example, the number of job vacancies rose from 8,000 in 2005 to 20,000 in 2006. "The market is flooded with vacancy announcements," says Jurgita Paskevieiute, company manager for the Search & Selection recruitment agency in Vilnius. "Many companies choose to lure away employees from their rivals. Although it is a costlier recruitment process, it is more effective." Paskevieiute said the number of requests that her company received to poach employees in January 2007 was equal to the last six months of 2006.

Those who remain behind know they can pick and choose their jobs. Employers get minimal response to their job ads and those who do apply feel no sense of long-term commitment. Job turnover has increased and wage demands have soared to completely unsustainable levels (currently 18% year-on year in Lithuania, 20% in Estonia and 30% in Latvia), which in turn fuels inflation.

Entrepreneurs are becoming disillusioned. A typical example is restaurateur Endijs Berzins, who has established several successful chains in Latvia. After years of rapid expansion, the labour shortage is hurting business: "In 2003, around 300 waiters and 190 cooks answered job advertisements, but this year there was absolute zero," says Berzins.

When companies can't find employees domestically, they are seeking them internationally. According to the Office of Citizenship and Migration Affairs of Latvia (OCMA), in the first 10 months of 2007, the number of officially registered guest workers in Latvia was 4,000, twice the number of workers in the whole of 2006. The main donor countries are Ukraine, Moldova and Uzbekistan. In Lithuania, Interior Ministry figures show that short-term residence permits issued for work purposes climbed from 386 in 2002 to 2,085 in 2006. In all statistics cited above, this year's totals look like being much higher.

Demographic changes are exacerbating the situation. As in Western Europe, the Baltic populations are shrinking. Between 2005 and 2007, for instance, Lithuania's population dropped by around 30,000, to fewer than 3.4m.

Improving healthcare and social security systems are slowing the natural decline somewhat, but population growth remains negative and the proportion of older economically inactive citizens is increasing. They need pensions, which can only be paid for by introducing tax-paying new workers into the economy.

The Estonian model

The labour shortage in Estonia is less acute than in Lithuania and Latvia. The smallest of the Baltic states, Estonia is also regarded as the most sensitive to perceived threats to its culture and society, and has already established an effective system for registering and processing short-term migrant workers. The annual influx has been limited to a maximum of 0.1% of the population, and migrants must be able to earn 1.24 times the average Estonian wage - meaning only skilled workers need apply. A healthy population of skilled Ukrainian shipbuilders working in the Tallinn shipyards bears witness to the scheme's efficiency, as does an estimate that just 3% of Estonia's workforce is overseas, compared with Lithuania's figure of 15% and Latvia's 10%.

"I believe that the importing of so-called cheap or low-skilled labour is not, at least in Estonia's case, a solution to our problems. It would just delay the necessity of solving serious problems and would keep our pay scale artificially low," Estonian Foreign Minister Urmas Paet said earlier this year.

Instead of importing workers, Estonia is investing in research and development, attempting to turn itself into an economy that is small but efficient. State funding for research and development in 2001 comprised 0.75% of GDP. By 2006, it was 1.5%. In 2007, a five-year extension of the government's "Knowledge-based Estonia" master-plan will ramp up R&D spending to a level comparable with Finland and Japan. The three key industries around which the economy will be based are information technology, biomedicine and materials technologies.

Whether Latvia and Lithuania can be similarly decisive is open to question. Their track records on joined-up government are not impressive. Their more ethnically, religiously, and linguistically-mixed populations are harder to marshal, and their governments are less stable. Recent attempts to address the issue have tinkered with the detail of inadequate existing legislation instead of adopting root-and-branch reform.

"It costs more than €850 for an employer to register a foreign worker in Latvia and around €145 in Lithuania," says Elina Egle of the Latvian Employers' Confederation, which is campaigning for a more Estonian approach. "In contrast it costs just €36 in Estonia. We need to cut the administrative burden."

For investors, the real danger is that unless the labour shortage is tackled properly, the Baltic economies will stall for want of workers. Wage growth is comfortably outstripping productivity gains already and clear signs that the Baltic economies are already cooling off means there is no reason for émigré workers to return home. And if the Baltic states (and Poland, the Czech Republic and Slovakia) do manage to use the influx of foreign workers effectively, investors might want also to check their portfolios for Ukrainian, Moldovan and Uzbek companies which could be next in line for a labour exodus.

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