The Baltic Depression: Lessons For The Rest Of Europe?
The three Baltic economies of Estonia, Lithuania and Latvia have been the biggest losers of the 2008-2009 global financial crisis, contracting by 14.1%, 14.8% and a whopping 18.0% in 2009 respectively. After overheating in the preceding three years (Latvia grew on average 10.9% between 2005 and 2007), tightening global credit conditions towards the tail-end of 2007 saw the Baltic house of cards come crashing down.
This was largely due to the fact that these tiny European economies were almost entirely propelled into stratospheric growth by cheap credit, which fuelled an unsustainable construction and real estate bubble. Credit to the private sector came from foreign loans to Latvian and Lithuanian banks (mostly from Scandinavian lenders). However, concerns about the overheating of these economies and a housing bubble desperately in search of a pin have seen credit seize up, sending the local mortgage markets crashing down. Without the swift support of the IMF and EU, the implosion of the local financial sector – albeit relatively small in size – would have sent shockwaves across Europe, and especially the Scandinavian economies, where banks were particularly exposed to the prospect of a default.
Unable to engineer inflation by devaluing the exchange rates – all three economies are contenders for eventual eurozone accession (Estonia is joining the single-currency bloc in January 2011) and thus locked in ERM-II – policymakers were forced to pursue a policy of internal devaluation. This means that the economy is ruthlessly recalibrated away from domestic consumption towards restoring some form of external competitiveness through painful wage cuts and a withdrawal of subsidies. The credit crunch then takes care of the rest, by forcing businesses across the board to scrap investments and administer enormous layoffs, forcing unit labour costs to come down.
This means that these economies will be characterised by fiscal austerity, household deleveraging and historically high unemployment, paving the way for negative or lacklustre growth. Indeed, Lithuania only posted its first positive year-on-year real GDP growth rate since Q308 in the second quarter of 2010, and this was almost exclusively driven by exports. So while a deeper crisis may have been averted for now, structurally the imbalances have hardly unwound.
Lithuania - International Investment Position, EURbn
A look at Lithuania’s net international investment positions shows the smoking gun of the Baltic state’s economic depression.
Although 31.5% of total liabilities are in the form of foreign direct investment (FDI) – which is a positive due to the long-term nature of such investments, almost half of total liabilities are in the shape of ‘other investments’, of which the bulk are foreign loans.
Lithuania - International Investment Liabilities, EURmn
Of total foreign loans to Lithuania, some 72% go to banks, equivalent to well over a quarter of total liabilities! Though this has started to come down since the heyday in 2008, the chart above pretty much backs up what Risk Watchdog has been implying for quite some time now: the Baltic economies will remain regional laggards and heavily rely on foreign financing to avoid another meltdown, which could force monetary authorities to devalue.
Lithuania - Other Investment (liabilities), EURmn
Wider Regional Significance
Why is this significant from a broader regional point of view, given that Lithuania, for instance, is only a EUR35bn economy? Well, first of all, a lot of the problems in the Baltic states are reminders of what could be facing the least competitive Southern European economies, such as Greece, Portugal and even Spain. In both cases the authorities are unable to inflate their way out of the debt burden and highly uncompetitive export sectors. Painful internal devaluations are pretty much inevitable.
Lithuania - Gross Average Monthly Earnings (same quarter of previous year=100)
And the kicker… Unlike Central and Eastern Europe, where divergence will be the name of the game over the next decade, the eurozone is not so lucky, as it’s too closely integrated to sustain a ‘three-speed Europe’. Indeed, Risk Watchdog believes that Germany will ultimately be forced to foot the bill for the Southern European states, which underpins my colleagues’ conviction that Europe will be the big underperformer in the global economic growth story over the next several years.