What Are the Chances of Economic Crisis in the Baltic States?
By Rudolfs Bems

How sustainable are recent macroeconomic developments in Estonia, Latvia, and Lithuania? This article looks at the driving forces behind the recent Baltic GDP growth and its implications for external imbalances and capital investments in the Baltic states.

Since the 1998 Russian crisis, the economies of the Baltic states have posted remarkable performances. Following a short-lived local crisis in 1999, all three countries experienced rapid growth in 2000 and 2001. During this period the Baltic states were the fastest growing transition economies and among the fastest growing countries in the world. The economy of Latvia, which was the most successful of the three, grew by 14.9 percent during the period, while the economies of Estonia and Lithuania grew by 12.5 and 9.9 percent, respectively. This rapid growth trend continued into the first half of 2002.

Throughout the transition process, economic growth in the three Baltic states has been accompanied by a negative trade balance and by growing bank credit to the private sector. At times, when growth rates have been particularly high, trade imbalances and credit growth in these countries have tended to reach record levels. The current growth episode is no exception. In 2001 Latvia’s trade deficit reached 20 percent of GDP, and during 2000-01 bank credit to the private sector increased by more than 70 percent in real terms.

With the current prospects for accession to NATO and the EU, the Baltic states’ future appears bright, and this is no doubt the driving force behind the recent GDP growth. Consequently, capital is flowing into the region and overall investment is on the rise. The Baltic states have no problems with financing their large trade deficits. In addition, their bright future prospects and the wider availability of credit have encouraged local companies to borrow money and the local population to increase consumption. According to the Latvian authorities, only 2.6 percent of bank credits are classified as bad debt.

Despite the recent success, the current economic situation in the Baltic states points to two potential problems. First, the continuous inflow of foreign capital is unlikely to be sustained in the long run, implying that export growth will need to be faster than import growth. To date, however, there is no evidence of such a trend, especially in Latvia. Second, the growth of bank lending to the private sector is likely to encourage import growth more than export growth. For example, in 2001 the wholesale-retail trade sector received the largest proportion of investments in Latvia, outpacing manufacturing. Given the state of commerce after the collapse of the Soviet Union, such a development does not come as a surprise. Nevertheless, it is likely to make the trade balance even more negative by encouraging import consumption. Similarly troubling is the observation that consumer credit has been growing rapidly in Estonia and Latvia, with growth rates of 85.5 percent and 65.9 percent, respectively, in 2001 alone. Although consumption growth is an inherent part of economic development, it is likely to generate more imports.

Overall, the allocation of investment resources through banks plays an important role not only in determining the overall level of economic activity in the Baltic states, but also in determining the sustainability of the current negative external positions. Thus in Latvia, where bank lending increased much faster than in Estonia and Lithuania, the trade balance has also deteriorated much faster. More in-depth research is needed to understand how efficiently capital inflows are invested in the Baltic states and if they will eventually generate the needed exports.

Beyond local developments, as the Baltic states become more integrated into international markets they become more vulnerable to exogenous shocks. For example, persistent recession in the EU is likely to have a negative effect on exports from the Baltic states and thereby worsen the trade balance. At the end of 2001 and during 2002, all three Baltic states had already experienced negative effects resulting from economic slowdown in the EU.

Economic development in the Baltic states is unlikely to continue at its current pace without setbacks. These countries are likely to experience "corrections" that will put credit growth in line with developments in the rest of the economy. Trade deficits are also likely to be reduced. Government policies have limited influence on these corrections, although they can help, for example, to avoid further worsening of the current account balance, the government should at least have a balanced budget during years of rapid economic growth.

Finally, we foresee setbacks to development in all the developing countries; however, these setbacks are not all bad and often represent needed adjustment. Speed is the factor that determines successful outcomes, that is, quick recovery from a crisis. Some of the Asian countries have resumed rapid growth since the 1997 Asian crisis, as did Russia since its crisis in 1998. Also the Russian crisis helped the Baltic countries redirect exports toward the EU. By contrast, Argentina has been devastated by its recent crisis and is unlikely to recover any time soon. Thus the Baltic states should always be prepared for a crisis and make sure that they can recover from it rapidly.

This article first appeared in full in Baltic Economic Trends (2002, no. 3), a joint publication of BICEPS (see http://www.biceps.org/) and SITE (see http://www.hhs.se/site/). Rudolfs Bems is a PhD student in economics at the Stockholm School of Economics and is currently spending a year at Princeton University on a research fellowship.