Baltic Regional Report
Baltic Countries See Strong Growth, but Pitfalls Remain
May 8, 2014
- Credit revival essential to sustained growth
- Design of appropriate policies can help secure export growth
- Reducing high unemployment requires structural changes
The Baltic economies performed well in the last two decades relative to other transition and emerging market economies, but they face common obstacles to continued strong economic growth.
The IMF’s latest report on the economies of Estonia, Latvia, and Lithuania calls for policy measures to help resuscitate credit growth, maintain strong export growth, and address certain issues in the labor market. According to the report, coordinated national and regional policy responses will help the countries sustain economic growth going forward, particularly in light of their membership (or prospective membership) in the euro area.
The IMF’s “cluster reports,” as they are called, focus on economic analysis of logical groupings of economies and consider the policies of these countries in an integrated way. The reports aim to highlight shared concerns and policy lessons to policymakers and, where relevant, how shocks might move across economies and how countries can potentially benefit from policy coordination.
This new approach complements the IMF’s current approach to economic surveillance, which up until now has consisted of bilateral surveillance (the on-the-ground appraisal of individual member countries) and multilateral surveillance (the high-altitude oversight of the world economy).
The Baltics are small, highly open, economies with strong economic links to the Nordic countries and each other. Their financial sectors are among the most open globally, and their economies are characterized by high levels of foreign direct investment and trade. The Baltics trade mainly with each other and other European countries, in part as a result of increased EU integration.
In all three Baltic countries, income levels are converging toward those of advanced economies. Whether because of their economic model, the links to the Nordic countries, membership in the EU, or other factors, the Baltics managed to reduce the income gap with advanced economies over the last two decades.
The Baltic countries face common challenges, but there are also some issues specific to each country.
Growth has been strong and credit is growing again in Estonia, but there are signs of labor market overheating in spite of the still high level of unemployment. For the longer term, there may be scope for tax policies and education and training to reduce the apparently high structural unemployment rate. Latvia enters the euro area with the fastest rate of growth in Europe and market confidence is high, but investment has slowed down recently and credit continues to contract. Lithuania—the largest of the three economies—targets euro adoption for 2015 and its economy expanded at the second fastest rate in the EU. The surge in its exports sector over the past five years was particularly pronounced, reflecting in part a bigger share of its exports going to the CIS and Poland, which expanded strongly in this period.
The Baltic economies have all experienced “creditless” recoveries following the global financial crisis, though with some underlying differences. In Estonia, real credit is no longer contracting. In Latvia and Lithuania, where credit expansion is yet to resume, measures aimed at reducing the private sector debt overhang—such as improvements in insolvency regimes—could spur credit demand, while reducing credit risk and thus encouraging supply. Over the medium term, the Baltic economies could explore initiatives to deepen capital markets and reduce dependence on bank credit.
All three Baltic economies are aiming to increase high-skill, high value–added exports to rapidly growing markets, but they are competing with other countries in search of the same markets. The sophistication of Baltic exports has increased over time, but their comparative advantage remains in labor intensive goods and services, although Estonia has carved out a small advantage in knowledge intensive services in recent years. National policies to improve education and training would help the countries achieve these goals, but collective efforts to improve infrastructure links to the rest of the European Union are also necessary to improve competitiveness.
Unemployment remains persistently high in the Baltics and represents a key challenge. While it has fallen significantly from its post-crisis peak, it remains in the 8–12 percent range and is assessed to be largely structural in nature. It is particularly high for youth, and about half the unemployed have been out of a job for more than one year.
According to the IMF report, there is scope for policies to reduce structural unemployment. Neither minimum wages nor unemployment benefits appear excessive when compared to other Organization for Economic Cooperation and Development countries, so policymakers could focus attention on reducing the labor “tax wedge,” which is a measure of the difference between labor costs to the employer and the net take-home pay of the employee. High tax rates on labor income tend to depress labor supply and employment, and expand the shadow economy.
Skill and education mismatches also appear to be a concern in the Baltic economies, while spending on active labor market policies is very low. Policymakers can therefore take action to emphasize education and training, and expand active labor market policies.
There are strong economic links between the Nordic and Baltic countries, including in the financial sector, trade, and foreign direct investment. The Baltic countries all have financial sectors dominated by Nordic-headquartered banking groups. Nordic countries are also large direct investors in the Baltic countries, particularly in the case of Estonia, where Nordic investors account for more than half of total foreign direct investment. Trade links are also considerable, although the shares are lower than for banking and foreign direct investment.
The Baltic countries follow similar approaches to economic policy, broadly in line with those of Nordic and the Anglo-Saxon countries. They are closer to the Anglo-Saxons than the Nordics in the structure of their public sectors, but they have a revealed preference for conservative and business-friendly fiscal policies, much in line with both the Anglo-Saxon and Nordic countries. Generally, they have good macroeconomic policies, which helped them weather the 2008–09 financial crisis.