IMF Survey: The Baltic Party Need Not End in a Bust
February 19, 2008
- Per capita incomes in the Baltics have risen by up to 50 percent since 2004
- But exceptional growth has been accompanied by big external imbalances
- Seminar identified how to achieve a soft landing
Growth in the Baltic countries (Estonia, Latvia, Lithuania) has been exceptionally high.
Indeed, their performance over the past decade and a half is almost unprecedented in post World War II history. Year after year, GDP has grown much faster than in emerging market peers, let alone Europe (see Chart 1). Membership of the European Union (EU) provided an extra boost, with per capita incomes increasing by up to 50 percent since 2004.
Lately, however, the economic headlines have been dominated by unwelcome news, from negative industrial output growth in Estonia to double-digit inflation in Latvia. Credit from foreign parent banks, which until recently fueled growth in the real estate sector, has slowed markedly. 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 contended that their rapid convergence has been too much too fast, be proven right after all? Now that cheap global financing is drying up, will the imbalances built up during the boom—large current account deficits (see Chart 2), heavy private sector debt burdens, and overheated real estate markets—end in a bust? Academics and policymakers at a high-level seminar, jointly organized by the Estonian Central Bank (Eesti Pank-EP) and the IMF on February 1-2 in Brussels, debated the policies needed to avoid the experience of other countries that went from boom to bust—and what makes the Baltic case so different. With the right policies in place, they argued, a soft landing is feasible.
To be sure, nobody questions that the risks of a hard landing are real. Some observers point to the case of Portugal. It, too, experienced a rapid acceleration of economic convergence after joining the EU. But starting in 2001 this boom gave way to a long period of sub par growth and high current account deficits that persist until today, as big wage increases exceed productivity growth and the country has lost competitiveness. Other observers draw parallels to the 1998 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 ago, capital, labor, and product markets in the Baltics are already deeply integrated with their European neighbors (see Chart 3), especially the Nordic countries. This provides protection against sudden stops, but also limits policy options.
What makes the Baltics different?
Three fundamental factors distinguish the Baltics from the usual pathology of emerging market countries caught in a boom-bust cycles.
• Capital markets are very open. Financial deepening has not only proceeded extremely fast, it has been accompanied by a very high degree of international integration: Baltic banks are de facto owned and operated by Nordic banks and domestic credit is largely financed from there. Since these parent banks have a strong stake in the Baltics' economic future, a sudden Asian-style stop of financing is unlikely. By the same token, however, these close ties put the fate of the Baltic banks into the hands of just a few Nordic banks and their ability to weather the global financial turmoil.
• Labor is highly mobile. The opening up of the British and Irish labor markets—where wages are considerably higher—has encouraged Baltic workers to seek employment abroad. So 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 leave. This is fundamentally different from the textbook case, where labor endowments are usually assumed to be immobile.
• Governments have a strong commitment to maintaining fixed exchange rate regimes. This has provided a crucial anchor of stability in good and in testing times, such as the Russian crisis. Abandoning these 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. Policymakers from the Baltic countries, the European Central Bank, and the European Commission also firmly rejected suggestions to periodically revalue the exchange rate (Paul de Grauwe, University of Leuven) or to unilaterally introduce the euro (Willem Buiter, London School of Economics). Ruling out monetary and exchange rate policies does, however, put an even heavier burden on remaining policy levers.
Olivier Blanchard, addressing the seminar, said that a fiscal stimulus would be a false solution. (photo: Michael Chia)
How can a soft landing be achieved?
The EP-IMF seminar identified four elements of a comprehensive policy package to avoid a boom-bust cycle and achieve a soft landing.
• 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, Professor Olivier Blanchard (MIT) argued 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. From that standpoint, it would be better to rely on incomes policy if that was thought to be effective.
• Second, facilitate the switch of production and investment from non-tradables to tradables. This means, for example, removing tax distortions that favor investment in real estate and improve the business climate for export-oriented sectors like manufacturing or tourism. Structural reforms would also increase productivity growth, in line with the goals of the Lisbon agenda.
• Third, wages should be flexible, and free to increase or decrease as warranted by companies' competitiveness and productivity conditions. Inward migration into the Baltics can help. Jakob von Weizsäcker (Bruegel) argued that temporary workers from neighboring CIS countries can replace those natives who, because of their EU citizenship, can legally work in other member countries. As Tito Boeri (Bocconi University) pointed out, such issues are best addressed through a coordinated EU-wide approach.
• Fourth, strengthen financial supervision. As credit growth is decelerating, the focus is now 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.
"Change the optic from promoting growth at all cost to consolidating the recent gains and ensuring that external debt is serviced" is how Michael Deppler (IMF) summarized the proposed policy package. 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 lasts forever.
Participants at the IMF/EP seminar asked governments and citizens in the Baltics to take this lesson to heart and to 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.