Where are the Baltic Tigers heading?

The Baltic countries have been bestowed with several nicknames to portray the spectacular economic success of the region since the mid-1990s. The weekly The Economist introduced the term ‘Lynx economies’ and others have talked about a ‘Baltic Miracle’, but the ‘Baltic Tigers’ is probably the most lasting idiom. In all cases, the moniker express the great surprise of the Baltic countries doing so well in economic terms after the difficult transition in the beginning of the 1990s. The question is now whether the impressive macroeconomic performance can continue or there are difficult times ahead for the countries?

The three Baltic countries regained their independence from the Soviet Union in August 1991, facing a multitude of problems. Large parts of the administration had to be built from scratch, inflation reached hyperinflationary levels, and trade with the former East Bloc countries was severely disrupted. The period until the mid-1990s saw a very large decline in GDP in all three countries, although the magnitude of the declines is still disputed. The subsequent boom is, however, not in doubt, and annual growth rates in the double digit range have not been uncommon. The figure below shows annual GDP growth on a quarterly basis from the first quarter of 1995 to the fourth quarter of 2007.

The figure clearly shows the very high trend growth in the Baltic countries, only interrupted by the downturn in 1999 as fallout from the Russian crisis. Given the low initial income levels, part of the impressive growth performance can probably be explained by ‘catch up’, where import of technology and organisational knowledge speed up growth. In 2006, the purchasing power adjusted GDP per capita in the Baltic countries still amount to approximately 50-60% of the EU27 average.

The figure also points to a spurt of growth (especially in Estonia and Latvia) starting in 2004, i.e. around the time when the Baltic countries joined the European Union. The magnitude of the subsequent boom has surprised many observers and policymakers in the three countries. In hindsight the growth spurt may be less surprising, since the countries received very large capital inflows as reflected in large current account deficits. (Scandinavian banks in particular have expanded lending to their Baltic subsidiaries.) The capital inflow led to lower interest rates and make credit more readily available, which then stimulated domestic consumption and investment.

It is clear that double digit growth rates and current account deficits in the range of 10-25% of GDP cannot be sustained in the longer term. The question is then how the adjustment will take place. Two scenarios are indicated. A ‘soft landing’ scenario foresees a gradual reduction of lending from abroad and a subsequent cooling of the Baltic economies. A ‘hard landing’ scenario amounts to a crisis scenario, where a shift in expectations leads to capital flight, pressure on the exchange rates and a rapid contraction of credit. The result will be significantly reduced domestic demand and an economic downturn. The likelihood of each scenario is difficult to assess. A number of investment banks and other analysts have drawn up a gloomy picture of future events in the Baltics. Against this stands the fact that all three countries have stable fixed exchange rate regimes, which have proved resilient previously, e.g. during the Russian crisis. Furthermore, the countries have already implemented a number of measures to cool down the economies, including fiscal measures and higher reserve requirements on the bank.

Most importantly, however, may be the strains in world financial markets, which started with the subprime crisis in the US more than half a year ago. The financial crisis has led banks and other financial institutions to reduce lending, implying substantially tighter borrowing conditions in the Baltic countries. Meanwhile, the crisis has meant that short-term interest rates have been lowered instead of increased as widely expected a year ago. The positive side effect of this is that indebted borrowers in Estonia, Latvia and Lithuania will not face larger debt servicing payments, which again may reduce the likelihood of widespread bankruptcies. The global financial setback may thus have led to exactly the form of financial restraint that the overheating Baltic countries need.

Preliminary data for the fourth quarter show a marked slowdown in all three countries and in particular in Estonia and Latvia, the two countries most prone to overheating. Meanwhile the current account deficits appear to be heading in the right direction. Overall, it seems as if the Baltic countries can breathe a bit freer; the big financial meltdown is unlikely to materialise. Instead, the countries likely face a period of slower growth and expansion of the export sector. I should hope is that such a cooling will also slow down prices increases as the Baltic countries currently have an inflation problem; this is a point I will return to at a later stage.

Readers interested in more on the economic developments in the Baltic countries may wish to read my recent overview article ”Economic Development in the Baltic States: Success and New Challenges”, published in Monetary Review (National bank of Denmark), no. 4, 2007, pp. 79-96: http://www.nationalbanken.dk/C1256BE9004F6416/side/3CD2C815D21B921FC12573D4004DA5E4/$file/mon_4qtr07.pdf.