Tough road ahead for slowing Baltic economies

By Patrick Lannin, Reuters

RIGA, May 26 (Reuters) - If the pessimists are right, dark times lie ahead for the Baltic States as they slow sharply from double-digit economic growth.

Should the optimists’ view materialise, the countries are simply on the road to a more sustainable pace of development.

What is clear is that a slowdown, partly caused by Scandinavian banks cutting the credit they were earlier doling out in large amounts, is making the Baltic ride to the Euro zone an even greater challenge, especially given roaring inflation.

All three countries, which have currency boards and currency pegs to the Euro, hoped to adopt the single EU currency soon after joining the bloc in 2004, but inflation has pushed back these plans to between 2010-2013 at the earliest.

In the meantime, governments must tighten their belts and find new ways to generate growth in the absence of the huge consumer demand that was fed by the credit boom.

“The much-hyped soft landing (in Latvia) is not on the cards,” said Morten Hansen, an economics professor at the Stockholm School of Economics in Latvian capital Riga.

“The growth of the economy is contracting much faster than expected by most and if developments in Estonia are a good yardstick as to what will happen here, and it often is, a recession is very likely,” he added.

Nordea analyst Anssi Rantala agreed: “It is fairly obvious now, especially in the case of Estonia and Latvia, that these economies are heading to, or are already in, a recession.”

The reversal of fortunes has been one of the sharpest among the new member states of the European Union. This time last year, the fear was of overheating due to surging growth rates.

But Estonian growth slumped in the first quarter to 0.4 percent year-on-year and Latvia was down to 3.6 percent. Lithuania was a more healthy 6.4 percent, but it generally lags the cycle of its neighbors and is expected to slow further.

The slowdown came after Scandinavian banks, including market leaders Swedbank and SEB, turned down the credit taps. This led to a slump in the property and construction sectors and a decline in retail sales.

LONG HAUL

Now the Baltic countries are back to the basics of finding ways to stimulate growth without the credit drug.

History does give some reason for hope. Before the credit boom began in 2004, Baltic economies were expanding at healthy rates of 7, 8, or 9 percent a year. But there are no quick fixes.

“Basically, it is down to a more serious look again at long-term structural reforms,” said Hansen.

Boosting exports is a key goal, though the rise in inflation through domestic prices as well was wage gains has weakened the competitiveness of Baltic-made products.

One factor working in the region’s favour is that Russia — still a key export market for the former Soviet states — continues to boom. Nevertheless, the Baltic governments face a difficult job in keeping the slowdown and decline in revenues from hurting their public finances.

Estonia has already had to pass a supplementary 2008 budget to cut spending. Latvia will likely have to tighten its purse strings to make its 1 percent of GDP budget surplus goal.

The policy of Lithuania, going to elections in October, is looser, though it aims to balance its budget this year.

Will any after-effect of the slowdown be a full-blown economic crisis of a scale that could force a change in the currency board pegs or create systemic problems for banks?

Economic volatility in 2007 created bouts of panic selling in the Baltic markets, but few people expect a devaluation and governments and central banks strongly deny any chance of one.

The fact that between 75 and 80 percent of mortgages are in foreign currency, meaning devaluation would hit people’s ability to repay, argues against government steps to devalue.

But with inflation running at 17.5 percent on an annual basis in Latvia, at 11.4 percent in Estonia and 11.7 percent in Lithuania, there are genuine concerns.

For instance, Latvian money market rates beyond three months are above those of the Euro zone. The six-month rate is 6.35/7.05, while that for the Euro zone is 4.81/4.92.

Nordea’s Baltic trading head, Aku Hentila, said the spread was due to poor liquidity, but also higher uncertainty.

“I don’t think that there is an imminent threat to these pegged currencies, particularly from speculative attacks,” he said, noting that pressure on the lat last year had failed.

At the same time, inflation is high and growth is slowing.

“Today, the peg issue might not be that attractive to the authorities (to discuss), but if time goes by and the economy continues to deterioriate a lot, they will need to re-think their stance.” (Editing by George Obulutsa, Reuters)

Source: Reuters

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