Agata Urbanska of ING Commercial Banking -
There are two competing images that come to mind when thinking about the Baltics. The first one is that of "European tigers" - a phrase coined to reflect the fast pace of structural reforms in the 1990s and the high pace of GDP growth throughout most of the 2000s. The second, less favourable one is that of "boarding the Titanic" as they forge ahead with adopting the euro, unfazed by the Eurozone's troubles.
The average annual growth rate in the 2000-07 period reached over 8% in the Baltics, following over 5% growth in 1996-99. That compares with 4% and 3% average growth for the CE3 (the Czech Republic, Poland, Hungary) in the same periods. Baltic outperformance has been accompanied by booming investments (including foreign investment) and sharply rising credit. GDP per capita has surged. As a percentage of the EU15 average, GDP per capita advanced to 36% in 2008 from a mere 9% in 1995. Estonia has had the best track record - GDP per capita quadrupled in 1995-2008 to 44% of the EU15 average, recording the fastest pace of real convergence among any of the new EU member states.
The 2009-10 period saw a sharp GDP contraction and real de-convergence, but that was nowhere close to cancelling out previous gains. The outlook for 2011 is much brighter with growth rates having returned to positive territory from mid-2010. The boom and bust of the last decade has, however, revealed the unsustainability of the growth model that the Baltics pursued. We expect that having fully recovered by 2012-13, growth rates will be in a 4-5% range rather than the pre-crisis 8%-plus.
The bad, the good and the better
The Baltics' main point of vulnerability was the high indebtedness of the private sector and misperception of high potential growth. The seemingly tight fiscal policies turned out to be too loose. Credit extension, especially to households, in the pre-crisis period was increasingly based on unrealistic wage rise expectations. Annual wage growth peaked at some 20% nominal rate in 2007 in Lithuania and Estonia and over 30% in Latvia, topping out the trend that started around mid-2004 from just less than 10% year-on-year nominal wage growth previously. Credit growth had been the strongest in Estonia, with growth accelerating from 20% on year in 2000 to 60% in 2006 in real terms. This saw a shocking rise in the stock of private credit to 94% of GDP in 2008 from just 24% in 2000. Latvia and Lithuania have seen a similar pace of credit expansion, though the stock of credit in Lithuania reached only 60% of GDP by 2008. Cracks had already started appearing in this dynamic in early 2007, but the 2008 global financial crisis demolished it.
The key to maintaining the prevailing fixed exchange-rate regimes (introduced in the mid-1990s) was the fact that majority of the external debt was owed to Scandinavian banks who invested in the region on the basis of a strong long-term commitment. Given this background, the Baltics at least did not suffer huge capital outflows once the crisis hit. However, the aftermath of the credit bust was the bursting of the real estate bubble. The collapse of export markets on the back of the global financial crisis additionally contributed to the sharp economic contraction in 2009.
The good side of the story next to the limited capital outflows was the flexibility of the Baltic economies, which allowed them to adjust successfully. Real estate prices halved in 2008-09; unemployment rates quadrupled and wages dropped on average 10% in 2009. The crisis saw the biggest domestic bank nationalised in Latvia, which also had to turn to the International Monetary Fund and EU for financial support. But these negative trends stopped and reversed in 2010. In early 2011, we are now looking at declining unemployment, while industrial production and exports are experiencing double-digit growth and wages growth is turning positive, though the deleveraging continues.
What caught international attention was the re-election in October of the government that was responsible for a series of harsh fiscal cuts since March 2009. Lithuanian Premier Andrius Kubilius' governing party fared much better than expected in municipal elections in February, coming second behind the main opposition party. And Estonian Prime Minister Andrus Ansip widened his government coalition's majority in elections held in March. This consistency in the Baltics in terms of their commitment to the prevailing exchange rate regimes, Eurozone membership targets and general public acceptance of harsh fiscal measures has in particular surprised markets and impressed politicians in other EU countries. Some speculate it is driven by an "easy come, easy go" attitude that cannot work, for example, in Greece, where people are used to lax policy. The other key point for the Baltics is their commitment to the euro/EU against a history of Russian dominance. In contrast, numerous, and on occasion violent, public protests against fiscal tightening have rolled through the peripheral Eurozone countries. Greek police reported a total of 496 protests and marches last year as the government passed tax increases and budget cuts to meet the terms of its EU loan. Ireland's austerity programme, bank bailout and international loan led to an election win for the opposition in February, the biggest political shift in the country's history.
On the mend
All three Baltic countries beat expectations for growth in the fourth quarter of 2010. But they are facing a change to their growth model that will result in lower GDP growth rates than in the 2000-07 boom. However, these should be sustainable, thus a shift away from the boom-and-bust growth pattern. The general direction is for a smaller contribution from consumption growth, less credit growth and more exports. Indeed, net exports contributed positively to GDP growth in 2010 on strong exports rather than weak imports as was the case in 2008-09 and against the 2001-07 years of strong domestic demand growth and a negative contribution to growth from net exports. In 2010, exports to GDP, a measure of the openness of economies, have jumped higher some 15 percentage points to close to 60% in Estonia and Lithuania and by 10 points to 36% in Latvia. We assume these changes will largely be sustained in the future. Still the key challenge for authorities in the Baltic region is to sustain cost competitiveness, but equally also develop other avenues of outperformance, targeting high-value added industry and supporting investments (including foreign) with a good business environment, limited red-tape, etc.
The surge of current account imbalances in 2007 has put the fixed exchange rate regimes in the Baltics in the spotlight. There were a number of voices arguing for devaluation as growth collapsed in 2009. All the Baltics were consistent in sticking to their pegs versus the euro, a policy that has been proven as correct. Wage adjustments and the recovery of external demand were sufficient to deliver exports growth. The huge current account deficits at 15-22% of GDP in 2007 turned into surpluses in 2010. The absence of devaluation has preserved debt sustainability. External debt in the three countries varies from 90% to 160% of GDP. The ratio jumped from 120% to 160% in Latvia between 2008-09 as GDP shrank by 20% in nominal terms, but devaluation would have risked an even sharper deterioration with no guarantee of a boost to growth through exports. The high external debt ratios are one of the main arguments for euro adoption, a plan that a number of other EU members in Central Europe have seemingly suspended for now. Estonia adopted the euro in 2011, unfazed by the unfolding euro crisis, and Latvia and Lithuania are credibly targeting 2014 for euro adoption. The main challenges on the way are the Maastricht criteria on the general budget balance and inflation. The latter in particular is the main risk for a delay.
Agata Urbanska is Senior Economist at Emerging Europe ING Commercial Banking
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