The Baltics–Avoiding the Portuguese Trap

On January 31, Fitch followed its earlier move on Lithuania and downgraded the outlook for Estonia and Latvia, citing “heightened downside risks.” Is the Baltic party, with per capita incomes surging by up to 50 percent since EU accession alone, finally coming to and end? Now that cheap financing is drying up in the wake of the global credit crisis, will the imbalances built up during the boom—very large current account deficits, heavy private sector debt burdens and overheated real estate markets—end in a bust?  

My co-bloger Karsten Staehr doesn’t think so (see his blog yesterday). Nor did the participants at a recent seminar of academics and policy makers (from the Baltics and the EU institutions), jointly organized by the IMF and Eesti Pank ( which both Karsten and I attended. The comon verdict was that with the right policies in place, a soft landing is feasible.   To be sure, nobody questions that the risks of a hard landing are real. Some point to the case of Portugal which also experienced a rapid acceleration of economic convergence after joining the EU. Starting in 2001 this boom gave way to a long period of sub par growth and high current account deficits that persist until today. The culprit: large wages increases driven by unrealistic expectations which exceed productivity growth and undermined the country’s competitiveness. Other observers draw parallels to the Asian crisis, where a rapid expansion of foreign-funded credit preceded a painful sudden stop and a collapse of fixed exchange rate regimes. While some of this may sound alarmingly familiar, none of these comparisons quite stick. Having joined the EU only four years go, the Baltics economies are already deeply integrated with their European neighbors. Figure 1, which was developed by my IMF colleague Ashok Mody, illustrates just how much this process has accelerated in the past years. This provides protection, but also limits policy options.  



In particular, the financial sector is de facto owned and operated by Nordic banks. Since these banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding seems unlikely. By the same token, however, these close ties put the fate of the Baltic banks into the hands of just a few Nordic parents and their ability to weather the global financial turmoil.  

Another anchor of stability have been the currency boards in Estonia and Lithuania, and the quasi-fixed exchange rate in Latvia. These pegs have proven to be remarkably resilient, surviving the Russian crisis as well as recent attempts by outside market players to take positions. Speculators have not found a chink in the armor because the spot market is tiny and a forward market non-existent (contrary to the impression generated by those quotes on Bloomberg screens). From the Baltic governments’ point of view, abandoning the euro pegs, even in the face of mounting external pressures, would likely create more problems than it solves, given that many households and enterprises have borrowed in euros. But ruling out monetary and exchange rate policies does, of course, put an even heavier burden on remaining policy levers.  

What can Baltic and EU policy makers do to avoid Portugal’s or Asia’s fate and to secure a soft landing? The EP-IMF seminar identified four elements of a comprehensive policy package.  

·                    First, fiscal policy should not seek to offset a contraction in demand, even if the Baltic economies enter a period of slow growth. Drawing on Portugal’s experience, Olivier Blanchard (MIT) argued at the EP-IMF seminar that a fiscal stimulus would be a false solution. More public spending would drive up prices and wages and undermine competitiveness. After all, the heart of the problem is insufficient external, not internal, demand. ·                    Second, facilitate the switch of production and investment from non-tradable sectors to tradable sectors. This means, for example, to remove tax distortions that favor investment in real estate and to improve the business climate for export-oriented sectors like manufacturing or tourism. ·                    Third, wages should be flexible and remain in line with companies’ competitiveness and productivity conditions. While low unionization and a traditionally high degree of labor market flexibility suggest that the Baltics could do better than Portugal in keeping wage growth in check, the scope for doing so is limited by the threat that workers would emigrate. In fact, many have already left for better salaries in the UK and Ireland. This is fundamentally different from the textbook case, where labor endowments are usually assumed to be immobile. One solution to the dilemma is to ease up restrictions on inward migration from neighboring CIS countries. ·                    Fourth, strengthen financial supervision. As credit growth is decelerating, the focus should now be shifting from discouraging excessive lending to ensuring that financial institutions are well prepared for an economic downturn. Like migration, this is a formidable task requiring close cross-border cooperation within the EU, in this case between national financial supervisors in the Baltics and the Nordic countries. This package changes the optic of economic policy from promoting growth at all cost to consolidating the recent gains and ensuring that the external debt (100 percent of GDP and more) accumulated in the boom years is serviced. The global credit crunch may in fact prove to be a blessing in disguise as it dampens the access to cheap financing and, more fundamentally, serves as a reminder that no boom can last forever.  

The lesson for the governments and citizens in the Baltics is that they should lower their expectations, be it with respect to income growth, large-scale public investment projects or speedy euro adoption. Modesty and prudence are the best insurance against falling into the Portuguese slow growth trap—or experiencing a sudden Asian-style output contraction.

9 Responses to "The Baltics–Avoiding the Portuguese Trap"

  1. Mary Stokes   February 14, 2008 at 8:08 pm

    I really enjoyed reading your comment. You seemed to cover all the bases in the debate over a hard or soft landing for the Baltics.In laying out the policies these countries should be following to achieve a soft landing, you mention, ‘fiscal policy should not seek to offset a contraction in demand.’ According to a recent Latvian Abroad blog post (link below), it looks like Latvia may not be getting the message. The post says that Latvia’s government is now concerned the slowdown will be sharp and is considering boosting the economy by spending more and earlier in the year. a fiscal stimulus like this be enough to derail Latvia’s potential for a soft landing?Thanks again for your great post!

  2. Sebastian Dullien   February 15, 2008 at 4:22 am

    Very interesting post. However, I am much more sceptical than you when it comes for the Baltic’s prospects of avoiding the Portuguese trap. To me, these countries’ currencies seem to be hopelessly overvalued already. Not only run these countries huge current account deficits, also real estate is more expensive in the Baltic capitals than in Berlin or Frankfurt. Moreover, if you happen to go out to eat in Talinn, count significantly more (in absolute terms) than in Berlin. (See my Eurozone Watch post at ) on this.While flexible labour markets are fine, I doubt whether they will bring about falling nominal wages. In addition, even if they do, this would wreck havoc on the private households’ balance sheets, depressing growth for years to come.In my opinion, the Baltic countries only have one chance: Devalue by 30 percent on the eve of the euro adoption. Legally, this is possible: There is no rule which says that you have to adopt the euro at your central parity in the EMS. Given Germany’s long agony after entering EMU at an overvalued exchange rate and Portugals situation now, the Baltic countries should be extremely careful how to enter EMU. After all, I still remember the time in the 1990s when Portugal was doing much better than Spain and everyone praised the “flexible Portuguese labour market”…

  3. Anonymous   February 15, 2008 at 10:54 am

    All is well, it’s just that by saying “First, fiscal policy should not seek to offset a contraction in demand” the guy is apparently not quite listening to what his boss, DSK, is saying. And DSK is saying this: ” Unless the situation improves, the fiscal authorities in countries with low fiscal risks should also prepare to exploit the headroom for timely and targeted fiscal stimulus that can add to aggregate demand in a way that supports private consumption”. Well, if Latvia with its extremely low government debt does not have a room for fiscal action, then I don’t know who else has…

  4. Claus Vistesen
    claus vistesen   February 20, 2008 at 3:17 pm

    Splendid post Christian and so by the way was Karsten’s. I plan to do a more thorough of the arguments you and Karsten field in a note over at my own blog but here are nevertheless some initial observations. Firstly, I am also not as optimistic as you. I agree however that it all depends on whether the foreign banks are willing to follow many of the Eastern European economies down into much lower growth rates and possibly a recession (i.e. think Hungary here). The second point is of course these pegged exchange rates which Sebastian also refers to. If the pegs go and/or if the Forint and Leu tanks the latter point quite realistic at this juncture we will end up in this translation risk mess where households need to service foreign denominated debt with depreciating cash flows. This will clearly only exacerbate the relative downturn. On the labour market front you say … ‘One solution to the dilemma is to ease up restrictions on inward migration from neighboring CIS countries.’I am sorry to be a stinker here but in my honest opinion this is does not make much sense. We need to remember the big picture here and how the whole region is basically being depleted from people at a staggering pace. This has two main drivers. One is the steady outflow of migration to Western Europe which I might add is NOT a risk; it is happening and has been going on for many years. The real risk is however that these flows intensify once the slowdown really sets in. This would seriously undermine the human capital base. The second point is demographics in general and how these countries quite simply have moved through the demographic transition much faster than economic development has been able to keep up. This in my opinion is the real problem here and ultimately also why the Baltics (save perhaps Estonia) will never enter the EMU. I mean, why should they? I know that I sound alarmist and I really do not want to be a doom and gloom preacher. However, the idea that intra-regional migration can alleviate the region wide problems simply is not true since this is all one big zero-sum game.

  5. Edward Hugh
    Edward Hugh   February 24, 2008 at 4:54 am

    Hi everyone,Sorry I am a latecomer to this mini debate. I have put up a post on Baltic Economy Watch with a link here, and I do consider there some of the arguments which were presented at the seminar in more depth than I obviously can here. Essentially I agree with Claus, in the sense that I think that the collapse in inetrnal demand is very rapid, but that wages and prices remain very “sticky” (and in part I would argue this is due to the demographic structure of the Baltic States where the labour market – in terms of people with serviceable human capital levels – has become incredibly tight). The situation is now turning (and unemployment seems to have bottomed in Latvia in November, and started to rise in Estonia as of January), and since labour market data is normally a lagged indicator, this would seem to imply that we are now well into the slowdown, a point which is evidently confirmed by other data like retail sales or industrial output growth. So what we may face is a process where younger and more able bodied workers up and leave in search of work elsewhere, while older ones take early retirement. In any event the net pool of available local workers may well be even further reduced by the sharpness of the slowdown, and the first thing I found missing from the seminar was any real discussion of how to avoid this undesireable situation in the short term.Indeed this brings me to the whole meat of my issue with the sort of solutions – eg – Oliver Blanchard was presenting, namely their term structure. The Baltics evidently face major long term challenges, but they face a short and very immediate term crisis. Most of the measures being suggested related to the longer term, but the real problems are arriving now, and responses are needed, otherwise more structural damage will be done, and this will complicate things even more in the longer run.This is the whole issue about the “convergence” argument, since people seem very unclear about just what part of economic growth and performance is “path dependent”, and how short term factors and initial conditions can influence longer term outcomes. In this sense I would say Portugal is a clear case of path dependence, although I don’t know enough about Portugal to say anything useful beyond noting that I am not THAT convinced of the parallels between Portugal and the Baltics. A large fiscal deficit was one of the key items in what happened in Portugal, recent events in Hungary (which have, of course, been very different from the Baltics) may in fact be more related to the Portuguese experience. My feeling is that what has been happening in the Baltics may not be a repeat of something which has happened previously, but rather a fresh phenomenon, which can be studied and learnt from to help us anticipate what might happen elsewhere (although it has to be said that events are now moving generally with such a velocity that it is hard to see us having much time to “learn and assimilate” anything before the whole damn goose is cooked). In Bulgaria, Romania, Poland, the Czech Republic (for example), but not forgetting Ukraine, and now Russia, where many of the Baltic syndrome symptoms seem now to be well advanced. Moscow flat prices rose 10% month on month in Febraury, nominal wages are rising around 26 to 27% pa, and inflation is up round 12%. I think it is no accident that they also have the combination of declining population, low male life expectancy and very rapid “catch up” growth in Russia. The only important structural difference is perhaps that instead of receiving remittances from out migrants (Russia, of course, has a million a year plus inward migrants) they receive oil revenue, but the impact on very tight labour capacity is just the same.So the new phenomenon here is that people are trying to get prototypical “catch up” growth, when they have already entered the second demographic transition, and not – as in the normal case – in the midst of the first transition. Logically this means doing the “catch up” thing without the normal benefits of the “demographic dividend”. People who don’t agree that “demographics matter” tend to chant till they are blue in the face that the transition from positive demographics to the demgoraphic dividend is not a mechanical one, and of course it isn’t, and we have this whole batch of countries who for political/institutional reasons didn’t get the modern growth regime when they had their demographic transition, but people rarely stop to reflect on this. Well, don’t worry, since as Hegel pointed out the “Owl Minerva” has an unpleasant habit of only flying after dusk, and what we don’t have the time or energy to think about in the opportune moment will tend to come back and smack us in the face in the shape of an inconvenient external reality when the time comes.The whole issue at the present time then seems to be whether what we are into is a slow or a rapid downturn. All the charts I am looking at read rapid (in quite red letters), and I really don’t know which charts the people who are saying this will be a slow landing are actually looking at at the moment. Additionally, and as I argue in my BEW post, “the banks will steer us through” argument seems to founder a bit on the fact that these banks also have to think about their own credit ratings (and that of their Baltic subsidiaries, which is being systematically downgraded), and if their risk premiums rise this can affect the rating of all the debt they have on their books. This is just one of the reasons people argue that on balance sheet items are more of a restraint on bank lending than SIVs, and this is one of the reasons why the Scandinavian banks will need to take more action about their Baltic position than most people are contemplating.So things will, I think, move very rapidly now, and I wouldn’t be surprised to be seeing recession type signals coming from these economies before the year is out (and possibly within six months). The question is, will the ultimate landing be soft or hard?Basically, I think this will depend on what happens to the currency pegs. If they hold, the landing may be extremely painful, but soft, and by soft I mean here what happened in Portugal or Germany post 1995 (which Sebastian mentions). For demographic and migration reasons we have a very tight labour market, so we may expect (and of course the latest Q4 wage rise and PPI evidence simply confirm this) a very slow and protracted downward adjustment in wages – say 5 years, and even more if we treat Germany as an example – while productivity works to make wages competitive again even without very large reductions in nominal wages. But the point people need to get clear on is that this would be the SOFT LANDING. This is the kind of landing Hungary now has.The danger to this soft landing scenario (and we will leave out at this point the fact that these will, given the demographic scenario, and the need to get richer before getting old, be 5 critical years in Baltic history), comes from the fact that the pegs may not stand the strain. The real danger for a hard landing – in the Baltics, in Hungary, in Romania and in Bulgaria – comes from the possibility of a sudden downward adjustment in the currency. The reason for this is quite simple, since private households in all these countries have unhedged exposure to currency movements in the form of large quantities of non local currency debt. There is no doubt that should the Baltic pegs break, or the Hungarian trading band be scrapped large amounts of financial distress would be produced.So why the hell would anyone want to do this, you may well ask? Well basically noone seems to be doing any calculations about the long run comparative dynamics between a short sharp shock correction now (with an inevitable very substantial haircut for investors and covered bond holders, I could mention a case study country here, but I won’t) and the longer run path dymanics of five or more years of slow growth, steady out migration and struggling export price competitiveness. None of the situations here are easy, but taking the bull by the horns may well turn out to be the best remedy, especially given the strong risk that you may well end up in this situation at the end of the day anyway. Obviously it would help countries like the Baltics enormously if we had in the form of the IMF or the EU Comission proactive instititions who were capable of giving a clear lead. Ben Bernanke likes to talk about the use of “unconventional tools”. The Baltics are a clear case of economies where resort to the use of unconventional tolls would seem to be entirely merited and justified. Unfortunately I saw little discussion of such possibilities at the seminatr Christoph attended.Finally, Mary:”Would a fiscal stimulus like this be enough to derail Latvia’s potential for a soft landing?”Is this a typo????Did you mean:”Would a fiscal stimulus like this be enough to derail Latvia’s potential for a HARD landing?”This would make more sense to me as a viewpoint. As I explain in the Baltic Economy Watch post, the conditions which gave rise to the sound IMF advice to try and drain excess demand by running sizeable fiscal surpluses have now passed. We have now moved from a situation where domstic demand was running well in excess of capacity, we are about to get into the opposite problem and demand management runs both ways, and especially since given the presence of the pegs monetary policy is virtually non existent, a strong credit cruch is in place, and the total debt to GDP levels are very low. I am strongly in favour of running a temporary fiscal surplusin Spain in the face of the rapid contraction in domestic demand and the severity of the credit crunch here, and I see no reason at all why the same logic should not apply to the Baltics. Basically long term fiscal deficits are a luxury that cannot be afforded given population ageing, but for short term management purposes, for the life of me I cannot understand why not. Sound policy is based on the ability to discriminate between the short and the longer term in economic management decisions.In case you really where asking whether such a policy could “derail” the hard landing, personally I doubt it, but it would at least be doing something. The worst aspect of the whole situation is the lack of real initiatives at this moments. These economies have been left like a groggy boxer sagging on the ropes, just waiting for someone to come in “floating like a butterly and stinging like a bee” to administer the final KO. Sitting back with folded arms, and stoically waiting and watching is never a good policy.

  6. Edward Hugh   February 25, 2008 at 4:24 am

    Hi again,And just updating slightly. All the news from Estonia at the moment seems to be bad news. We had the Q4 wage increase data I mention above at the end of last week, and today we have the December trade data. I quote the statistics office release:****************According to the preliminary data of Statistics Estonia, in December 2007 the Estonian foreign trade turnover made up 22.4 billion kroons.a Compared to December 2006, the foreign trade turnover decreased 6% and, compared to November 2007 it decreased 19%.In December 2007 the exports were 9.3 billion kroons (42%) and imports 13.1 billion kroons (58%). Compared to December 2006, the exports of goods decreased 8% and the imports of goods decreased 4%. Compared to November 2007, the exports of goods decreased 22% and the imports of goods decreased 16%. The trade deficit was 3.8 billion kroons. In December 2006 it was 3.6 billion kroons and in November 2007 it was 3.8 billion kroons. *******************Imports are obviously decreasing as domestic demand (and reprocessing for export) declines. But crucially exports are down year on year by 8%, and the turnover decreased 6%. Given the increased level of openness in the Estonian economy (see the nice bar chart from Ashok Mody) this is important. Basically if we can assume there will be no significant revival in domestic demand in the coming months (and if the Estonian government add to this by keeping a very tight reign on fiscal spending, then exports are the only possible growth area. But with relative prices as they are, it is hard to see how this can happen. Basically productivity increases and sector shifts cannot hope to compensate in any adequate degree for the erosion of price competitiveness we are currently seeing, and we may still be facing several more months – at least – of this. By that point the damage will effectively have been done (if it hasn’t been already). I’m afraid ladies and gentlemen that the time for some very hard decisions on the currency peg front is fast approaching. I do hope that the IMF and the EU Commission/ECB are preparing some kind of contingency plan here. The big danger is that once all this breaks loose it can spread from one country to another like widlfire.Incidentally, Christoph says: “Since these banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding seems unlikely.” The thing is, a sudden withdrawal of funding is not that likely, but what these countries need is a continuous injection of funding to cover the CA deficit. So even if the banks were willing to continue to increase lending, the question is what would the money be borrowed for? To pay for imports presumeably.But since part of the adjustment programme involves a tightening of loan conditions inside Estonia, who is going to be able to do the necessary borrowing to attract in the funding needed to settle the monthly external account book? And if no one is able to borrow because the loan conditions are tightened, doesn’t this in itself provoke a correction in the trade deficit, but in an extremely violent way?I see Ott Ummelas in Bloomberg quotes Christoph this morning as saying that “risks of a ‘hard landing’ in Estonia, Latvia and Lithuania are ‘real’ due to rising trade imbalances in recent quarters. I couldn’t agree more.

  7. Mary Stokes   February 25, 2008 at 3:18 pm

    In response to my question, Edward, “Would a fiscal stimulus like this be enough to derail Latvia’s potential for a soft landing?,” and your response: “Is this a typo????”No, this wasn’t a typo!! Here’s why. I have no problem with fiscal stimuli being implemented when an economy is in imminent danger of recession, but Latvia is clearly still in the overheating stage and a stimulus package now seems premature. At this point, a fiscal stimulus would likely only prolong the overheating and enhance the chance of a sharp downturn in Latvia by further eroding confidence in the economy. Inflation accelerated to 15.8% y/y in January – the fast pace in 11 years! Is a fiscal stimulus really what’s needed right now?I feel like your agreement with the statement that “risks of a ‘hard landing’ in Estonia, Latvia and Lithuania are ‘real’ due to rising trade imbalances in recent quarters is somewhat contradictory with your support for a fiscal stimulus. It seems contradictory because a fiscal stimulus would likely further exacerbate the trade imbalance in Latvia, as a stimulus would increase demand for imports and do nothing to boost export capacity.

  8. Edward Hugh   February 26, 2008 at 10:20 am

    Hi again MaryThanks for the clarification. Now I understand your point of view a bit better. I think the key point is this one:”but Latvia is clearly still in the overheating stage”My feeling is that Lavia is no longer overheating. Possibly Romania, Ukraine and Russia are now at the point of sharp (going critical) overheating. Poland (and possibly Slovakia, which just had a sudden acceleration, and possibly the Czech Republic, which just had a sudden jump in inflation) is in the pre extreme-overheating stage, where about the only thing you can realistically try to do is hike the surplus abruptly (I mean we are talking short short-term improvised policy here, not long term structural solutions). I think Latvia left the extreme overheating stage in May-June (which isn’t to say there wasn’t a lot of momentum left in the system at that point. Take a look at the charts in my December Retail Sales post on the Latvia Economy Watch blog. Retail sales really peaked in the first quarter. Manuafacturing output has been in fierce retreat since July, the property market seems to have turned around May-June. In part this will be becuase a process as fierce as this almost has to choke itself out of its own accord, and also possibly because of the tightening of the credit conditions applied after April, and the impact on the housing market.Also if you look at my latest post on LEW on unemployment, this turned in October/November, and as I say this is a lagged indicator. So my feeling is the overheating situation is now dead and gone, and what people need to think about are cushions to try and soften the landing. Which is why I don’t see the same inconsistency in this as you do:”I feel like your agreement with the statement that “risks of a ‘hard landing’ in Estonia, Latvia and Lithuania are ‘real’ due to rising trade imbalances in recent quarters is somewhat contradictory with your support for a fiscal stimulus.”No. I don’t see it like this. During overheating clearly the sucking in of imports was fuelling the problem. But if we look at the latest numbers for December 2007, we can see that imports are now dropping back as domestic demand tanks (yoy imports were down 6.8% in December) while exports were up y-o-y 12.9%. So to some extent the trade imbalances are now improving, but the real problem is that with domestic demand unable to drive growth Latvia is going to have to “re-invent” itself as an export lead economy, and this means far stronger levels of export growth. In this context the “leading role” profile for Latvian exports is bound to be hampered by the ongoing loss of price competitiveness produced by all that inflation – which is still in the system, and is not going to simply disappear tomorrow. So there are now really only two alternatives left to correct this, severe wage deflation, or removing the currency peg. I think I have made it clear which I favour, though neither are easy to contemplate. If we go for the former alternative, and there is no fiscal support, the danger is that this deflation process can become very severe indeed. Especially if, due to the pressure towards out migration as a solution for young people, real wages prove to be much harder to initially adjust downwards than would normally be the case.

  9. Anonymous   March 4, 2008 at 2:02 am

    isn’t high growth of baltic countries just growth taken from the future, considering the debt and current account deficit? why this happend? ok, people want to live better. they want nice things. now! they’re impatient. politicians get elected if they have high GDP growth figures. but slower, solid growth on a much firmer ground is, in my mind, always better solution. cause hard lending can prolong this no-growth period to far.