China Research

In 2014, Estonia grew by 2.1%, Latvia by 2.4%, and Lithuania by 2.9%. Flash estimates for Q1 2015 report GDP growth dipping to 1.2% YoY in Estonia and Lithuania (contraction of 0.3% and 0.6% QoQ), and 2.0% in Latvia (still up 0.4% QoQ). Investment activity has been quite weak for a couple of years whereas consumption growth has remained by and large robust. Thus, the key reason for the dip in growth seems to be external, i.e.: (i) collapse in Russian demand, and (ii) subpar EU growth.

If subpar EU growth has tamed the upside for the Baltics (overall it still holds good growth prospects as the EU demand is still rising), Russian contraction and especially the rouble depreciation have an outright negative hit. The reason for Russia’s contraction is its chronic structural weaknesses (excessive dependence on oil, poor rule of law, weakness of market institutions) – reinforced by sanctions (impaired access to finance and technologies due to the sanctions from the West, but also Russia’s own imposed embargo on food imports) due to the Russia-Ukraine conflict.

Flash estimate for Q1 2015 reports Russian GDP to have shrunk by 1.9% YoY. Real household incomes are down about 10% YoY as are retail sales; investment activity seems to have fallen through the floor. It could have been worse… with oil prices gradually picking up, the rouble has stabilized at somewhat stronger levels than expected, which means that inflation, though still at about 16%, seems to have peaked and is likely to start retreating. Industrial output has reported small positive numbers. Still, Russia is set to shrink further this year and recession is likely to end only in 2016. Moreover, when recession will end, recovery will be bleak low single digits as its old oil-driven growth model has run out of steam and there is nothing broad and strong enough to substitute for it. So, there is not much hope for strong demand growth from Russia over the longer term either, even when ignoring the lagging rule of law, investor protection and geopolitical risks.

How does this Russia trouble affect the Baltic economies? It has cut sharply into the Baltic exports – in Q1 2015, goods exports to Russia fell by 29% for Latvia, 34% for Lithuania (-60% for Lithuanian origin goods) and 49% for Estonia from one year ago. More difficult to measure, but confidence must also have suffered, reducing investment activity. Yet, the overall impact is not that devastating at all. Despite the massive drop of exports to Russia, total exports have grown a tad for Latvia (up 0.4% YoY), and only marginally inched down for Estonia (-0.4%) and Lithuania (-3.8%; -4% for Lithuanian origin goods).  Thus, the good news is that the massive fall in the exports to Russia have been compensated with expansion in other (mainly EU) markets. So far we see only limited and contained impact – within certain sectors or companies – on corporate profitability and liquidity.

In short, the Baltics are coping quite well with this. One of the reasons is that it is not the first time the Baltics see something like that; during the 1998 Russian crisis, for example, dependence on trade with Russia was much larger than it was before the current watershed, so companies have been diversifying their markets for a long time. As to the sanctions – Russia has had a habit of introducing one off sanctions against specific goods already before and also quite regularly (e.g. there was a ban specifically on Lithuanian milk products in 2013). Companies know how to react in such instances. Yes, this is costly, but companies have seen it before and know what to do.

We expect the Baltic goods exports to Russia to fall by 30%-50% in 2015, and trade links with Russia to weaken substantially. Russia’s share in goods exports has been shrinking, e.g. for Latvia, from 9.4% in Q1 2013 to 6.8% in Q1 2015. To compensate for the shortfall in Russia, there has been a spectacular growth to many so far for quite exotic markets for the Baltic exporters such as Middle East, China or Japan. But the major volume growth has been already established to the core partners of the EU. The share of destination EU has risen, e.g. for Latvia from 70.9% in Q1 2013 to 75.4% in Q1 2015, and it is likely to continue going forward. If political alliances for the Baltics have clearly been with Europe, fast and lucrative export growth to Russia and its peripheral trade partners at times may have put politicians in a situation to weigh among political and economic alliances… now political and economic alliances are likely to become closer aligned, which will add to stability – and this is good.

We see the dip in early 2015 as temporary since a gradual pick up in EU growth (supported by ECB quantitative easing stimulus) must lift European demand and thus the Baltic exports and consumer spending. Overall, we expect the Baltics to grow by about 2% in 2015 and 3% in 2016. Slower than before, but not that bad either.

 

 

 

 

 

 

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

 

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