Can the Baltic economies adjust and grow?

Alessandro Turrini, Uwe Böwer, Julia Lendvai, 21 July 2010

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The Baltic countries, Estonia, Latvia and Lithuania, have been through a unique experience since their transition from command- to market-based economies. Impressive growth rates were recorded for more than a decade, but the building up of macroeconomic and financial imbalances created the conditions for current-account reversals and unprecedented boom-bust cycle dynamics.

The recession was severe for Latvia, which required assistance from the IMF, the EU, and other donors. Yet such financial tensions were more limited in Lithuania and Estonia – thanks largely to more prudent policies before the crisis.

Immediately following the crisis, the debate focused on whether a devaluation in Latvia could have helped align the objectives of external adjustment and growth in the short-to-medium run (Krugman 2008, Rosemberg 2009). Yet, not only has the Latvian peg proved resilient, but the Baltic economies appear determined to keep their fixed exchange rate arrangements at the centre of their strategy towards euro adoption, with Estonia having taken the necessary steps for adopting the single currency already in 2011.

The debate is now shifting towards medium-to-long term challenges (see for example Landesmann 2010). The issue is that of repairing the “growth-engines” that were responsible for many people doubling their incomes in the previous decade and that seem now to be broken. At the same time, the Baltic states must remain on course for a durable external adjustment. Are these objectives compatible? Which policy frameworks could help to meet this challenge? How well the Baltics cope with these challenges could serve as a lesson to other crisis-hit countries faced with a similar dilemma (Corsetti 2010).

To understand and address the questions at stake, we need to step back and review how the Baltics found themselves in this situation. There have been three stages of the boom and bust path.

Stage 1: Take-off

The highly successful catching up process of the Baltic economies since transition was initially grounded on strong fundamentals. Economic restructuring after transition and large scope for sectoral reallocation of resources and technological upgrading were at the basis of strong potential gains in total factor productivity. These prospects for productivity improvements, coupled with a comparatively cheap and fairly educated labour force laid the grounds for high investment returns and sustained capital accumulation.

Growth accounting analysis indeed suggests that catching-up in the Baltics was accompanied by vast productivity gains – among the largest in non-Asian emerging economies in recent times – and strong investment rates – which have been growing until 2007 (Figure 1).

Figure 1. Growth, potential growth and contributions from production factors

Source: Commission Services

Despite rapid capital accumulation, there was no concurrent rise in domestic savings. The prospect of EU accession, successful institutional convergence, and stability-oriented macroeconomic frameworks led to sustained capital inflows from abroad. The result was growing current-account imbalances.

Stage 2: Overheating

Growth slowed down considerably around 2007, before the financial crisis reached its zenith. What went wrong?

  • Starting from the early 2000s, the Baltic countries started overheating.

Growth rates were well above potential, a result which is confirmed both on the basis of production-function-based potential growth estimates (Figure 1) and predictions from growth regressions (Boewer and Turrini, 2009). Growth above potential was accompanied by tightening labour markets, growing inflation, and declining price competitiveness.

  • Demand dynamics started being driven especially by increased borrowing against the prospect of future growth and investment was increasingly channelled into housing and private services.

Fast-growing credit flows– mostly denominated in euro and in large part provided by Scandinavian banks – were increasingly financing the housing sector via mortgage loans. Growth during this period was largely concentrated in a handful of private service industries, some connected wit the housing sector (Figure 2).

Figure 2. Industry contribution to value added growth, 1995-2005

Source: Elaborations on EU KLEMS data

Simulations performed with the DG EFIN QUEST III Dynamic Stochastic General Equilibrium Model (Ratto, Roeger, and in't Veld, 2008) suggest that the type of growth that took place since the early 2000s was hardly sustainable. As reported in Figure 3, while productivity shocks can explain observed macroeconomic dynamics in the Baltics until 2001, the subsequent boost in housing investment coupled with a massive deterioration in the trade balance can only be explained if shocks raising access to credit also enter the picture (see also Lendvai and Roeger, 2010).

Figure 3. Replicating macroeconomic developments in the Baltics: DSGE model simulations

TFP shock                          TFP and financial convergence shock

Notes: Thick lines: simulated data. Thin lines: historical data. Simulations with the DG ECFIN QUEST III model calibrated to the aggregate Baltic region. Left-hand-side panel figures show the contribution of TFP growth to macroeconomic aggregates between 1995 and 2007 based on QUEST III calibrated to the Baltic States. Exogenous TFP set such that the implied labour productivity in the traded and non-traded sectors match observed labour productivity in the data. Right-hand-side panel figures show the combined contribution of TFP growth (1995 - 2007), a 100bp permanent fall in foreign risk premium (from 2001) and easing access to credit (from 2001) to macroeconomic aggregates in the Baltic States. Calibration of risk premium in line with values estimated by Lungnemitcherai & Schadler (IMF, 2007). Access to credit: implied households' debt to GDP ratio matches gross households' liabilities-to-GDP in the data.

Stage 3: After the boom cometh the bust

By 2006-2007, the typical ingredients of "boom-bust" cycles were present, to differing degrees, in the three Baltic economies.

  • Awareness of growing credit risks amid an unsustainable domestic demand boom led foreign and domestic banks to tighten lending standards.
  • Tighter lending conditions contributed to the slowing of the housing market, which in turn led to deteriorating credit quality and a further tightening of lending standards in a self-reinforcing spiral.

The bust phase was made particularly abrupt by global developments.

  • The process of financially-driven economic contraction was accelerated by falling asset prices, widespread deleveraging, and a flight to safety in financial markets following the global financial crisis.
  • The fall in external demand hit these small, open economies hard, leading to deep and sudden drops in GDP figures.

Falling exports were accompanied by a major drop in domestic demand, possibly triggered by a major revision in expectations regarding growth potential (European Commission 2010a).

  • After the burst of the crisis, the three Baltic countries carried out severe fiscal consolidation measures to stabilise rapidly rising government debt ratios and reassure investors, which further contributed to compress demand and GDP growth.

In 2009 the Baltics were hit by record recessions, with growth rates reaching -14% in Estonia, -18% in Latvia, and -15% in Lithuania. European Commission forecasts (European Commission 2010b) indicate for zero growth for 2010 in Estonia and recessions in the order of -4% GDP growth in Latvia and Lithuania.

What next?

Looking forward, the Baltics will have to devise a new growth model, and make it compatible with a durable adjustment of external imbalances.

The recent recession in the Baltics is mostly the result of a collapse in demand. But potential growth is also expected to lag behind in absence of substantial revision in policy frameworks (Figure 1).

The prospects for a recovery in total factor productivity growth will depend on the effectiveness government action. In this respect, improved infrastructure, including via frontloading and full absorption of EU funds, strengthened incentives to innovation and technological upgrading, and more effective education systems seem key ingredients of appropriate policy frameworks. As for investment, pre-conditions for its recovery are restored demand conditions, prospects for productivity improvements and stable financial market conditions.

Looking forward, conditions for external financing will be less favourable.

  • Current-account balances have adjusted considerably, but the stock of net foreign financial liabilities is still very large (about 55% in Lithuania and 78% in Latvia as of 2008 and 74% in Estonia in 2007).
  • In light of relatively high import-dependency, current-account deficits could emerge again as soon as incomes recover in the Baltic economies, which could put net foreign liabilities on an unstable path.

For the above reasons, and in light of the global credit tightening and increase in risk aversion in financial markets, the Baltic economies will hardly be in a position to rely on easy financing of large current-account deficits. In fact, a durable adjustment of its current-account position is among the policy objectives for Latvia included in the framework of the IMF- and EU-led programme.

Are growth recovery and external balance necessarily in contrast?

Reduced room for current-account deficits would imply subdued dynamics of domestic absorption. This in turn could impinge on investment rates and therefore on potential growth for some years ahead. However, the necessary structural adjustment of the economy to ensure balanced current accounts on a sustained basis would exert a positive role in the longer term.

  • A pre-condition for a durable external adjustment is improved price and non-price competitiveness, which is also a key condition to ensure the attractiveness of the Baltic economies to foreign investors. Moreover, many of the structural policies that help restoring price competitiveness and upgrade the export mix also help foster potential growth in the medium-to-long run through an improvement in productivity growth rates.
  • A more general point, possibly not sufficiently emphasised in the current debate, is that the process of external adjustment is exactly what is needed to fix the Baltics' growth engine because resources are shifted towards tradable sectors, where the prospects for demand growth are larger and where durable productivity gains are more likely.

A progressive increase in wages and prices compared with competitors, coupled with a progressive shift of resources into private services and housing is exactly what took place, to different extent, in the three Baltic countries in the past decade. However, the growth prospect of those non-tradable sectors is limited by domestic income and their potential for total factor productivity growth is lower.

Hence, a process of structural adjustment of the Baltic economies towards the tradable sector is a condition not only for a durable adjustment of their external position but also for sustained growth in the long run. Such an adjustment would involve short-run costs, but the faster and deeper it will be, the earlier the conditions for durable growth rates will start to return.

References

Boewer, U and A Turrini (2010), “EU accession: A road to fast-track convergence?”, Comparative Economic Studies, 52:181-207.

Corsetti, G (2010), "The 'original sin' in the eurozone", VoxEU.org, 9 May.

European Commission (2010b), Cross Country study: Economic Policy Challenges in the Baltics, European Economy Occasional Paper No. 58, February.

European Commission (2010a), European Economic Forecast – Spring 2010, European Economy No. 2, May.

Krugman, P (2008), "Latvia is the new Argentina (slightly wonkish)", The New York Times, 23 December.

Landesmann, MA (2010), "Which growth model for Central and Eastern Europe after the crisis?", FIW Policy Brief No. 4, May.

Lendvai, J, and W Roeger (2010), “External deficits in the Baltics – 1995-2007. Catching-up or imbalances?”, European Economy Economic Papers No. 398.

Ratto M, W Roeger, J in ’t Veld (2008), “QUEST III: an estimated open-economy DSGE model of the Euro Area with fiscal and monetary policy”, Economic Modelling, 26:222-233.

Rosenberg, C (2009), "Why the IMF Supports the Latvian Currency Peg", Roubini Global Economics, 6 January.

Topics: Europe's nations and regions, Global crisis
Tags: Baltic states, Fiscal crisis, global crisis

Economist at the European Commission, DG Economic and Financial Affairs

Economist at the European Commission, DG Economic and Financial Affairs

Alessandro Turrini

Economist and a Head of Unit, DG Economic and Financial Affairs, European Commission; and Research Affiliate, CEPR