Avoiding the Portuguese Trap

by Christoph B. Rosenberg
IMF Senior Regional Representative for Central Europe and the Baltics
Published in The Baltic Times
February 20, 2008

On January 31, the rating agency Fitch followed its earlier move on Lithuania and downgraded the outlook for Estonia and Latvia, citing "heightened downside risks." Will the skeptics, who have long considered that the Baltics' rapid convergence (with per capita incomes surging by up to 50 percent since EU accession alone) has been too much too fast, be proven right after all? Now that cheap financing is drying up in the wake of the global credit crisis, will the imbalances built up during the boom—large current account deficits, heavy private sector debt burdens and overheated real estate markets—end in a bust?

Participants at a recent high-level seminar jointly organized by the IMF and Eesti Pank (Bank of Estonia) did not think so. With the right policies in place, the policy makers and academics concluded, a soft landing is feasible.

To be sure, 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 wage increases, fueled by unrealistic expectations, which exceeded 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. 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 has been the currency boards in Estonia and Lithuania and the quasi-fixed exchange rate in Latvia. Abandoning these 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. Ruling out monetary and exchange rate policies does, however, 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 free to increase and decrease in line with companies' competitiveness and productivity conditions. The scope for doing so is, however, limited by the threat that workers would emigrate. In fact, many have already left for better salaries in the U.K. and Ireland. One solution to the dilemma is to ease up restrictions on inward migration from other 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.

This package changes the optic of economic policy from promoting growth at all cost to consolidating the recent gains and ensuring that the large external debt 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.

Christoph B. Rosenberg is IMF senior regional representative for Central Europe and the Baltics



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