Baltics Face Testing Times as Economic Boom Reverses
Until last year, the three small Baltic countries of Estonia, Latvia and Lithuania, with a combined population of seven million people, had been among the star economic performers in the EU. The Baltic states’ real GDP growth expanded by a spectacular annual average of 8.8% between 2003 and 2007, compared with a rather more sedate 2.2% in the EU15. This growth performance powered their real convergence with the EU, raising the average per capita income levels in the region closer to the EU median. The extended consumption and investment boom, however, fuelled by massive capital inflows and rapid bank credit growth, in the context of exchange rates that are pegged to the euro, triggered an overheating of the Baltic economies and widening macroeconomic imbalances.
All three Baltic countries had double digit current account deficits in 2006 as well as in 2007: at 23% of GDP in 2007, Latvia’s current account deficit was the largest of 105 Fitch-rated sovereigns, while Estonia’s and Lithuania’s were 18% and 14% of GDP respectively. At 14%, Latvia had the highest year-on-year inflation rate in the EU in December 2007, while Estonia’s was the third highest at 10%.
There are now clear signs that the Baltic economies are experiencing, to varying degrees, a slowdown as economic gravity reasserts itself. Domestic demand is contracting and Estonia and Latvia have both recorded two consecutive quarters of negative growth this year (in seasonally adjusted, quarter-on-quarter terms), suggesting the economies are in recession.
In Latvia, year-on-year nominal credit growth to the private sector slowed to 20% in June 2008 from 60% a year earlier, and property prices have fallen by around 20% over the past year. Estonia’s year-on-year credit growth rate slowed to 20% in June 2008, from 40% a year earlier, while property prices have fallen by 18% from April 2007 to June 2008. While Lithuania’s economic boom was more modest than those of Latvia and Estonia, and consequently its external and internal imbalances are less marked than those of its Baltic neighbours, real seasonally adjusted quarter-on-quarter GDP growth began to slow in Q307 and was just 0.3% in Q108, although it picked up to 0.9% in Q208.
Construction confidence surveys have been negative in all three Baltic states since Q407, while industrial and consumer confidence has also deteriorated – leading indicators of economic activity – suggesting that the slowdown in the Baltic states will continue. A correction from excess and exuberance to a more sustainable growth path is inevitable and desirable. The question now is: how long and deep will the slowdown be?
Our concerns about the severe overheating of the Baltic states and the increased risk of a costly adjustment to a more sustainable growth rate, overstretched external finances coupled with persistent double-digit inflation, led us to take a number of negative rating actions. We downgraded Latvia’s foreign currency rating to BBB+ from A- (A minus) in August 2007. Then in December, the agency revised the outlook on Lithuania’s A rating to negative from stable. This was followed in January 2008 by a revision of the outlooks on Latvia’s and Estonia’s ratings to negative.
Most recently, in October 2008, Fitch downgraded the foreign and local currency ratings of all three Baltic states by one notch and retained a negative outlook. Latvia’s foreign currency rating was downgraded to BBB from BBB+ and Lithuania and Estonia’s to A- from A. The rating actions reflected a heightened risk that the deterioration in the European economic and financial environment could impose a more costly macroeconomic adjustment given their large bank-financed current account deficits. All three Baltic economies are in the top ten of those with the largest gap between outstanding bank credit and bank deposits relative to both GDP and total bank credit.
The Baltic countries’ ratings – at BBB, Latvia’s rating is on a par with Bulgaria and Romania, while at A-, Estonia and Lithuania share the same rating as Poland and Malaysia – are underpinned by political and institutional strengths associated with their membership of the EU, strong medium-term growth prospects, low government debt levels, predominantly foreign-owned banking systems, and supportive business climates. All three countries are ranked in the top 30 globally in the World Bank’s 2009 ‘Doing Business Report’, ahead of ‘older’ EU members such as Spain and Portugal.
The extent of earlier macroeconomic imbalances and the speed of the correction now under way make it uncertain how the Baltic economies’ adjustment will play out. Fitch forecasts the Estonian economy could contract by 1.5% in 2008 before beginning to recover in late 2009. Growth in Latvia may slow less dramatically but the economy will take longer to recover – Fitch is forecasting annual GDP growth of 0% in 2008 and 0.5% in 2009. We forecast Lithuania’s downturn will be less severe than that of its Baltic neighbours but that the economy will continue to slow in 2009. Even if there is a rapid adjustment, it will take time for signs of a recovery to become clear. It could, therefore, be a testing 12 months for policy-makers, local residents and investors.
The likelihood of a relatively smooth unwinding of macroeconomic imbalances depends on the resilience of confidence of residents and foreign banks, continuing financing for the current account deficits and prevention of the spike in inflation feeding into higher price expectations, as well as on how quickly wage growth will moderate to correct the imbalances in tight labour markets. Even in this relatively benign scenario, sectors such as real estate, which were over-stretched during the boom, could undergo a relatively deeper and costlier slowdown. The sharp economic downturn, particularly in cyclical sectors, such as construction, coupled with falls in house prices suggest that bank asset quality is likely to deteriorate somewhat. The high share of loans to the commercial real estate sector and to the household sector for mortgage loans increases banks’ vulnerability to a fall in property prices.
Another factor is whether industry can restructure to increase exports at a time when the EU – the recipient of around three-quarters of Latvia’s and Estonia’s and two-thirds of Lithuania’s exports – is also slowing down. Recent new orders surveys and business and consumer confidence surveys in the euro area and EU15, which are leading indicators of activity, appear to reflect the softening in demand in western Europe. The downturn in its main export market, the EU, is a particular concern for the Baltic states, which are facing a sharp drop in domestic demand.
In addition, the Baltic countries may have to demonstrate the flexibility of their labour markets if industry is to maintain its competitiveness. Exceptionally strong wage growth has increased the pace of growth of the Baltic states’ real unit labour costs (particularly Latvia’s and Lithuania’s) above those of the euro area. Nevertheless, Fitch notes that in absolute terms prices and costs remain lower than in the Baltic countries’ main trading partner, the EU.
The Baltic states could also experience a painful and protracted slowdown though, particularly in conjunction with persistent high inflation, deteriorating competitiveness and problems in the banking sectors. Years of financial boom have left private sector balance sheets relatively stretched, which heightens the country’s near-term vulnerabilities and could act against a speedy economic recovery. Furthermore, with euro adoption now well beyond the rating horizon due to high and persistent inflation, Fitch considers that the support that potential eurozone membership provides to the Baltic states’ over-stretched external finances has diminished. We forecasts euro adoption may have to wait until 2013 for Estonia and Lithuania and 2014 for Latvia.
Fitch’s concerns for an overheating economy with a significant private sector external debt burden and a fixed peg to the euro were amplified in February 2007 when the Latvian lats weakened to the floor of its +/- 1% band on the back of rumours of an imminent devaluation, necessitating central bank intervention to support the currency. The exchange rate returned to the strong side of its band after April 2007 and the central bank recovered the reserves it had spent during its intervention in the foreign exchange market. Fitch believes devaluation would have a high economic and political cost in view of the high external debt burden and euro-isation of the Baltic economies. As such, we are of the view that the Baltic central banks and policy makers would take extreme steps to defend the exchange rate.
Furthermore, Fitch notes several market factors that weaken the likelihood of a successful speculative attack on the Baltic currencies. Shallow markets imply that there are few local-currency assets to sell or liquid investments to short-sell. Sustained fiscal discipline has delivered low levels of public debt for all three Baltic countries and the volume of local-currency debt held by foreigners is also low, as is stock market capitalisation, reducing the likelihood that this could be used as an avenue through which to attack the currency.
A currency crisis in the Baltics is also made less likely by the systematic involvement of large foreign-owned banks in the economy. Ninety-seven per cent of bank assets in Estonia, 68% in Latvia and 85% in Lithuania are foreign-owned. In all three countries, the banking system is dominated by the subsidiaries of Swedish-owned Swedbank and SEB. Fitch believes these parent banks are committed to long-term investments in the Baltic countries and will therefore continue to provide support to their Baltic subsidiaries and not act as counterparties to speculators looking to take positions against their currencies. However, Fitch notes that if these banks themselves were to face funding pressures that would be negative for the Baltic states.
A prolonged downturn could undermine confidence, while the global environment adds to financing risks. Although Fitch believes devaluation is unlikely, it is not impossible if there is a risk of a loss of confidence in the Baltic currencies and their banking systems, triggering a widespread conversion and withdrawal of deposits.
With domestic demand easing, the growth rate of tax revenues will slow and budget targets will come under more pressure as the Baltic economies weaken. With growth falling more sharply than expected, the Latvian and Estonian governments have lowered their planned budget surplus targets for 2008 and are making expenditure cuts. In Fitch’s view, there is a risk that the slowdown in the Baltic economies could have a greater impact on the public finances than their respective governments are projecting. Fitch is forecasting a budget deficit of approximately 0.5% of GDP for Latvia, 1.5% of GDP for Estonia and 2% of GDP for Lithuania.
We believe worse fiscal balances – in both cyclically adjusted and non-cyclically adjusted terms – should not present financing difficulties for the Baltic states, as government debt burdens are low and debt profiles are favourable. Estonia’s government debt burden was just 2.7% of GDP in 2007, the lowest in the EU and among A range credits; and at less than 10% of GDP in 2007, Latvia’s government debt burden is the third lowest in Europe. Lithuania’s government debt burden of 17% of GDP at end-2007 is the fifth lowest in the EU and also compares favourably to the A range median of 29%. Furthermore, all three countries are net public external creditors. Low and sustainable government debt burdens suggest that the governments would have room to at least partly allow the ‘automatic stabilisers’ to work by maintaining government spending – running a balanced budget or a small deficit – to protect their economies from a sharper slowdown than is necessary.
The Baltic economies face a difficult and uncertain 12 months, as they undergo a rapid rebalancing. How they fare will be of importance not just to the seven million Estonians, Latvians and Lithuanians but also to both European policy-makers wrestling with issues such as the speed of real convergence, the appropriateness of exchange rate regimes and the role of foreign banks, and to larger countries in the Balkans that face similar challenges.