China Research

The three Baltic countries have managed a spectacular roller-coaster in the economic growth lead tables of the European Union. Having ranked among the very top in the pre-2009 period, they suffered from the most severe contraction of economic activity anywhere in Europe. But then, just as many observers got ready to include the Baltics in the long list of unsustainable ‘growth spurts’ that failed to generate sustained prosperity improvements, they came back to again top the EU in terms of growth rates in 2012. What is going on, what can be expected to happen next, and what are the lessons to draw for other parts of Europe?

In assessing the current performance of the Baltic countries it is true that the extent of post-crisis growth was at least in part a reflection of the depth of the downturn that had occurred. The crises had been so deep and left enough capacity idle to make any upturn look strong. However, it is interesting to look more at the anatomy of the recovery. It did occur in the context of strict austerity policies and a still relatively flat level of domestic demand. A key driver was exports, which grew by around 30% in 2010 and 2011 and then slowed to in 2012 around 15% for Latvia and Lithuania and 4% for Estonia. But exports have over time also gained in terms of breadth of products and markets. This was not unexpected given the drastic improvement in relative unit labor costs in response to the ‘internal devaluation’ that the Baltic countries had implemented. But it was a process that seemed to have started already before. Most likely it had to-do with a broader re-evaluation of lower cost locations in Eastern Europe as China was getting more expensive and lost some dynamism.

For the immediate future, however, it is likely that growth will flatten. The 2013 growth rates were already lower; in Estonia they dropped dramatically. Trade has in 2013 fallen in Estonia and Latvia. The one-time opportunities of bouncing back after a crisis are by definition limited. The more structural changes in the attractiveness of the Baltics as an export platform might have the potential to support further growth. But the most attractive opportunities will have come first, and it is unclear how much more potential there is.

Domestic demand is in the meantime likely to recover somewhat as growth has returned and the economic outcome has stabilized. But is not going to support the kind of growth seen in the post-crisis recovery – unless a new overheating is being engineered. The repercussions of the crisis in the Ukraine and the erosion in relations to Russia have created further headwind: some of the recent export success had gone into Russia, the Ukraine, and the broader CIS region. And there could be a negative impact on the risk assessments that some investors make about the Baltics.

What lessons to draw depends on a deeper analysis of the run-up to the crisis and the policy decisions made in the Baltics thereafter? Here is my read: The Baltics weren’t perfect but they did the best given their abilities to implement the general guidelines that they received from Brussels. This was successful in improving the business environment and preparing the ground for investment and growth. But it failed to give the Baltics a clear strategy for competing in the market for export-oriented activities; most investments went into domestic-market serving sectors. And it did nothing to counter-act the danger of moving from catching-up to overheating on the back of private sector capital inflows; this was a blind-spot in the EU’s general policy framework.

During the crisis, the Baltics impressively – but also with severe social costs – dealt with the necessary re-adjustments of balance sheets and cost levels. There successful push towards Euro-Zone membership was the well-deserved price, and is a further asset in their efforts to attract foreign investment. But it also doesn’t amount to a clear strategy that would position the Baltic countries in terms of providing distinct value for specific activities and industries/clusters. Such strategic focus will be important to move beyond the competition based on lower cost, and mount an effective strategy for competitiveness upgrading and higher productivity in line with the capacity of local firms and government agencies.

Christian Ketels
Dr. Christian Ketels, Institute for Strategy and Competitiveness, Harvard Business School

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Following the sharp and deep recessions of the late 2000s when in just two years GDP collapsed by 24% in Latvia and respectively 20% and 16% in Estonia and Lithuania, the Baltic economies soon emerged as the fastest growing in the EU. Early in this decade when growth in Europe hovered just above zero, the Baltics were speeding ahead at (and sometimes above) 4-5% a year. All major imbalances were corrected – fiscal stance improved, large current account deficits erased, company and household balance sheets strengthened. As a sign of sustainability, Estonia was let into the euro area in 2011, Latvia in 2014, and Lithuania is set to do it next year. Lithuanian GDP is not far from the peak of the boom years while Estonia lags by about 4% and Latvia by 8%. GDP per capita and average labour productivity in all three economies are above their boom-time peaks. Unemployment is down from 20% to about 12% in Latvia and Lithuania, and just 8.5% in Estonia. What a recovery!

The latest data is, however, less cheerful. GDP growth has slowed down, though Latvia and Lithuania still pencilled in about 3% YoY in 1Q 2014. Estonia has been doing worse – last year it hovered at just above zero and hit surprisingly weak -1.9% YoY 1Q 2014. What should we expect going forward? The quick answer is that GDP growth this year is likely to remain quite contained at about 3% in Latvia and Lithuania, i.e., some weakening and then gradually gearing up as the growth in European export markets strengthens. As for Estonia, we may see a short-lived recession this year, but growth should come back as exports benefit from a strengthening recovery in Europe and cooling off in the domestic labour market.

Why is growth expected to slow? Some of the reasons are as follows:

First, the post-recession rebound is over. In times of heightened uncertainty, consumption and investment decisions get postponed, recessions often are harsher that the necessary correction and recovery kicks in sharply when the risks of further contraction wane and confidence improves. But it only takes you that far. It is like when you push down on a spring and then let it go – the rebound is sharp, but it runs out.

Second, the Baltic economies are small open economies and their underlying growth model is that of export-driven growth. The populations are shrinking and not yet wealthy enough to drive growth via consumption for long periods without capital inflows from outside. We already saw export to be the major driver in the early stages of the post-recession recovery – with labour costs brought down by slashing wages, reducing employment and raising productivity, exports picked up by double digits year-on-year. This renewed job creation, improved labour market confidence, consumption and thereafter also investment activity. With the lowest hanging fruits of improved productivity and competitiveness already picked, and external demand in major export markets still far from its prime due to still weak European economy, export growth has been lacklustre lately. Labour market has remained strong, and household consumption last year again became the major driver of growth. But one should not be fooled – consumption is strong only as long as labour market feels confident, and it is unlikely to be the case if exports contract or are flat for an extended period. In a cartoon language, consumption is no roadrunner – it cannot run from one side of a canyon to the other. Consumption is a coyote and unless helped by a roadrunner (read – export growth), it will fall down into a canyon (read – contraction in spending). Hence, the success to revive export growth will be a crucial factor for overall economic growth going forward.

Third, the Baltic economies are small open economies with free cross-border labour market mobility and still sizeable income gaps with more advanced EU economies. To reduce the risks of emigration and demographic/social problems going forward, wages need to grow. Falling unemployment rate has been putting an increasing pressure on the wage growth and we see that average real wage growth again exceeds that of average labour productivity. This can put competitiveness and export growth at risk, and we have seen unit labour costs rising, especially in Estonia. Unless productivity growth picks up, labour market will need to cool off to safeguard export competitiveness. Given that productivity gains are difficult to generate and typically are slow to come, this means that consumption growth will need to slow down, especially in Estonia where nominal wage growth so far has been the fastest. With labour market cooling off, wage growth slowing down, and more time to raise productivity, export growth should improve again.

Fourth, the breakout of the Russia-Ukraine conflict will have a negative impact on growth. So far the impact is minor (mostly linked to certain producers of processed food) feeding through the weakness of the rouble, but the conflict is also expected to postpone some of the investment activity. As long as the conflict does not escalate further by leading to energy supply interruptions, much deeper recession in the Russian economy and significant negative spill-overs onto the West European growth, this will have only a slowing effect on the growth in the Baltics, but not push the economies into recession. If there turns out to be recession (e.g., in Estonia this year), it is for other reasons. (For a more detailed analysis on the possible impact from the Russia-Ukraine conflict, see our latest Macro Focus http://www.swedbank-research.com/english/macro_focus/2014/april/index.csp)

Why will the Baltic economies grow? Over the past 15 years growth in the Baltics has seen massive swings on the upside and downside but the overall track record is impressive – GDP per capita (similar data also for average labour productivity) has gone up from ca 36-44% of the EU average to 65-75%. Many of the low hanging fruits have been picked and catch up will become more difficult going forward, but it will not stop. There are many reasons to be optimistic such as closer integration with the EU and continually improving institutions, but one of the major reasons is that populations are still hungry for income growth and better living standards. And so far this has proven to be very important to drive agility of the Baltic economies.

Major negative risks to the outlook: externally it is the weakness of export demand (e.g., due to the Russia-Ukraine conflict), internally it is lack of productivity growth and overheating of the labour market leading to the loss of export competitiveness.

Mārtiņš Kazāks
Swedbank, Deputy Group Chief Economist and Chief Economist in Latvia

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Poland is the six largest economy in the EU and the second largest EU country outside the monetary union EMU. For this reason, the issue of the future Polish joining of the euro is quite a steady topic in the press and economic analysis. However, the question is rather about the “when” than the “if” of joining (which, of course, is in line with the Maastricht Treaty).

What strikes me a lot in this context – I hope my impression is correct – is the picture that the Poles in a significant number of comments consider the joining of the euro predominantly as a political decision – and not primarily as an economic one. Sure, politicians have the final decision on the EMU entry unless a binding referendum is put into place. After the EMU entry, however, financial markets would take over the judgments on the Polish economy which clearly underlines the permanent need of a structurally strong and resilient economy. In other words: the economy matters a lot.

The view of the prominent political role in the membership process seems also being shared by current Prime Minister Donald Tusk who several times in the past months pointed at mostly political impediments for a euro membership. In reality, the formally delaying factor is indeed the need of a constitutional change before introducing the euro – since constitutional changes need a two-thirds majority in the Polish parliament which is not achievable any time soon. In other words, a broadly changing party composition in parliament is not in the cards. Will this locked situation open the way for a referendum at the end of the day?

In my view, the Poles can be happy about their current political and legal obstacles for joining the euro. I have followed and admired the development of Sweden’s neighbor on the other side of the Baltic Sea since 1990 (which includes dozens of trips to Warsaw and some other places). Sometimes the speed of reforms was quite high, sometimes more dampened. But Poland never really left the way of reforms or took steps back on this bumpy road.

This obvious continuity of economic policy must be seen as the key to the stable international confidence in Polish politics and reform activities in the past two decades.

But despite all these achievements: Poland is still a country that needs structural improvements. Currently, Poland does not suffer from major structural macroeconomic imbalances but the country would currently not really meet the convergence criteria as a whole for joining the euro.  In particular, the budget deficit is too high (which partly is reflected in somewhat excessive deficits in the current account). Improvements in other areas are also needed, for example further reforms of the pension system.

Thus: Why on earth should Poland any time soon destroy the tool of an independent monetary policy and the chance of choosing the interest rates it needs for the economy? Why should Poland in the foreseeable future go for a fixed exchange before really having created strong macroeconomic, microeconomic and institutional conditions? Why should the Polish government act against the will of the people which still clearly opposes to a Polish joining of the euro? Why shouldn’t Poland wait and see how the euro area as such will be developing in the forthcoming years?

And an important additional remark:  The flexible zloty served Poland well during the past years of global/European financial instability. Something to keep in mind! On the other hand, it cannot – and maybe it should not – be ruled that Poland can be ready for joining the euro at a later stage.

The big question is when Poland will be there…

Hubert Fromlet
Visiting Professor of International Economics, Linnaeus University
Editorial board

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