## _cr14116

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---

### Purpose and scope
- Examines common themes and challenges facing the three Baltic countries—Estonia, Latvia, and Lithuania (henceforth the Baltics).
- Aims to identify common features (including the Baltics’ revealed preference of economic model), common challenges, and national and joint policies to address them.
- Complements and provides background for issues discussed in the individual Article IV consultations for each Baltic country.

### Performance overview and recovery dynamics
- Findings:
  - Income convergence to advanced economies that follow similar economic models (e.g., the Nordics and the “Anglo-Saxons”) has been more rapid than in transition economy or emerging market peers.
  - Pre-crisis (by 2007) boom indicators:
    - annual credit growth reached an average of 36 percent;
    - current account deficits soared to 18 percent of GDP;
    - inflation rose to 10 percent;
    - bank loan-to-deposit ratios exceeded 200 percent.
  - After deep recessions in 2009, recovery featured:
    - Fast GDP growth by 2011 (fastest in the EU);
    - Export-led recovery reflecting competitiveness improvements;
    - Unwinding of imbalances: current account deficits near balance, bank loan-to-deposit ratios reduced considerably, low inflation, and declines in household and corporate debt.

### The Baltic economic model — characteristics
- Small, highly open economies with strong links to the Nordics and to each other.
- Financial sectors among the most open globally; high levels of FDI and trade.
- Banking systems dominated by Nordic-headquartered banks; reliance on parent bank funding high but declining fast.
- Non-bank financial sector relatively undeveloped.
- Macro features:
  - Small government: low government expenditure-to-GDP ratios; light taxation on income, capital, and wealth; relatively high social security contributions (labor taxes).
  - Prudent public finances: public debt around 30 percent of GDP for the region.
  - Monetary arrangements: currency-board-like stabilization historically; Estonia and Latvia adopted the euro; Lithuania applying to do so in 2015.
  - Labor markets flexible and more aligned with the laissez-faire Anglo-Saxon model than the Nordic “flexicurity” model.
  - Moderately high income inequality: Gini coefficients higher than the Nordics, similar to Anglo-Saxons.

### Income convergence
- Progress over two decades:
  - Starting from income levels of around ten percent of Nordic and Anglo-Saxon countries in 1995, the Baltics tripled their income levels as a share of Nordic and Anglo-Saxon per capita GDP by 2013.
  - Baltics have surpassed income levels of the CE4 and emerging OECD economies.

### Resuscitating credit growth — current situation, drivers, and cross-country variation
- Situation:
  - All three experienced a creditless recovery: post-crisis credit still declining in Latvia and Lithuania and weak in Estonia.
  - Private debt-to-GDP ratios declined considerably but remain elevated relative to pre-boom levels.
- Empirical context:
  - Creditless recoveries commonly follow rapid credit expansions and sharp corrections; the Baltics’ boom-bust cycle was steeper-than-average, suggesting a potentially longer period of negative credit growth, though historical experience points to credit resumption at this stage.
- Drivers by phase:
  - Boom: Domestic demand key. Non-financial private sector credit peaks:
    - 110 percent of GDP in Estonia and Latvia (from 30 and 40 percent of GDP six years earlier, respectively);
    - 70 percent of GDP in Lithuania (from 20 percent of GDP six years earlier).
  - Recession: Credit supply factors dominated; deteriorating bank asset quality associated with credit contraction.
  - Recovery: Both demand and supply matter; lending standards tightened during the recession and have not been substantially relaxed in Latvia and Lithuania; NPLs have declined but remain high.
- Cross-country variation:
  - Estonia: supply factors less important; healthier bank balance sheets; much lower NPL ratios; real credit contraction has ceased but remains weak.
  - Latvia and Lithuania: real credit continues to contract; lending standards remain relatively tight.
- Non-bank finance:
  - Capital markets, stock market capitalization, and venture capital remain small; banking dominates.
  - Financial integration with the Nordics (shared trading platform, coordinated regulation/supervision) helps access to investor pools, but short-run credit revival depends on the banking system.

### Credit growth and financial conditions — authorities’ and staff views
- Authorities acknowledged low credit growth as an issue; differing views on causes:
  - Estonia: weak credit growth attributed mainly to weak credit demand—weak investment activity, high retained earnings, and weak external demand; Estonia noted credit is growing there.
  - Latvia and Lithuania: cited credit supply constraints as important alongside demand factors; concurred with staff that anecdotal evidence supported this view.
- Observations:
  - "Credit growth remained negative, despite strong GDP recoveries."
  - Parent bank funding shrank and asset quality deteriorated, making banks more cautious.
  - Debt overhang has not been fully resolved.

### Export performance, FDI, and GVC participation
- Export achievements since 2000:
  - Latvian exporters increased world market shares by 100 percent.
  - Lithuanian exporters increased world market shares by 150 percent.
  - Estonia increased world market shares by 70 percent (having secured a very strong position prior to 2000).
- Export structure and drivers:
  - Market share gains broad-based for Latvia and Lithuania; Estonia concentrated more toward the Nordics and the United States (Estonia with a Nordic share around 40 percent).
  - During 2008–12, 35–45 percent of Baltic exports were products in markets that expanded relatively strongly globally.
  - Improved price competitiveness: post-crisis unit labor costs reduced by 10 to 20 percent relative to western European competitors due to wage restraint and productivity advances.
  - Services exports important; external services accounts in surplus for all three, with sophisticated services (ICT, "other business services") prominent in Estonia.
- FDI and GVCs:
  - Estonia’s FDI stock at about 80 percent of GDP — roughly twice that of Latvia and Lithuania; all three above the global median.
  - Swedish companies are the most important foreign direct investors in all three countries; Finland second for Estonia, the Netherlands for Latvia, Poland for Lithuania.
  - GVC participation: Latvia and Lithuania about the global average; Estonia substantially higher; all are considerably less involved in GVCs than the CE4.
- Vulnerabilities and concerns:
  - Export volume growth has come down sharply from earlier double-digit rates.
  - Baltic share of global FDI declined from about 0.4 percent during 2005–07 to about 0.2 percent during 2010–12.
  - Export sophistication remains concentrated in labor-intensive goods and services; high and medium-to-high technology goods account for a relatively low share compared to the CE4 and the euro area.
  - WEO projections indicate trading partner import growth for the Baltics is projected to decline substantially and fall below global trade growth.
  - Adverse demographics (aging, collapsed birth rates from early transition) pose challenges for labor supply and FDI attraction.

### Unemployment — scope, structural nature, and NAIRU estimates
- Current levels and characteristics:
  - Unemployment has fallen from post-crisis peaks but remains in the 8–12 percent range.
  - Youth unemployment is particularly high; about half the unemployed have been out of a job for more than one year.
- NAIRU and staff estimates:
  - NAIRU is estimated as high, stable, and close to current unemployment.
    - Lithuania and Latvia: time-varying point estimate ranges between 10 and 13¾ percent.
    - Estonia: ranges between 11½ and 16½ percent.
  - Current unemployment close to estimated NAIRU (2013) for Latvia and Lithuania; somewhat below estimated NAIRU (2013) for Estonia.
  - Implication: with output growing at potential, unemployment would not drop significantly without rising wage and inflationary pressures.
- Robustness checks:
  - NAIRU estimates align with historical average unemployment.
  - Real wage behavior: real wage growth accelerates when unemployment falls below NAIRU.
  - Beveridge curve and Okun’s Law coefficient have remained stable over time.
- Labor market institutions and ALMPs:
  - Minimum wages (as share of mean wage) are below or close to the OECD average.
  - Unemployment benefits much less generous than OECD average.
  - Employment protection in line with OECD average.
  - Spending on ALMPs:
    - Baltics spend 0.5 percent of GDP on ALMPs.
    - Nordics spend over 2 percent of GDP on ALMPs.
    - Of Baltic ALMP spending, only 0.1 percent of GDP is spent on training.
  - Passive labor-market supports and early retirement account for a significant share of total ALMP spending in the Baltics.
  - Skill mismatches are important; Baltics score worse than average on skill mismatch. Regional divides (e.g., higher rural unemployment in Lithuania) persist.

### Policy agenda — national recommendations
- Credit and insolvency:
  - Strengthen insolvency frameworks and administration to facilitate restructuring and resolution of household and corporate debt.
  - Suggested measures: fast-track legal processing, improve implementation of existing procedures, explore arbitration/mediation to reduce regular court caseloads.
  - Note limited direct levers over credit supply due to large presence of foreign banks.
- Export sector and competitiveness:
  - Maintain post-crisis competitiveness by aligning wage growth with productivity gains.
  - Promote firm entry and investment (supported by credit expansion) to boost productivity.
  - Address barriers in product and services markets to move into higher-skill markets and integrate into GVCs.
  - Improve skills to attract FDI; leverage favorable business-climate rankings while addressing R&D and public service inefficiencies.
- Employment and labor-market measures:
  - Reconsider labor taxation: reductions in the tax wedge are associated with declines in structural unemployment, but Baltic revenue-to-GDP ratios are already low. Options include shifting taxation toward capital and wealth, broadening bases, and improving revenue administration; consider coordination across countries.
  - Improve education outcomes and strengthen links between universities and employers; quality improvements in secondary education particularly in Latvia and Lithuania.
  - Increase spending and participation in ALMPs; prioritize quality of programs and use available EU funds.
  - Review benefit disincentives and "benefits traps"; examine tax incentives sustaining informal employment, especially in rural/agricultural activities.

### Policy agenda — joint/regional recommendations
- Rationale: small size and similarities justify integration, harmonization, and collaboration to achieve economies of scale.
- Recommended joint actions:
  - Develop the non-bank financial sector: facilitate cross-border investment, harmonize accounting and tax rules, consider alternative exchanges, regional ratings agencies, securitization, credit guarantee systems, and foster institutional investors; ensure strengthened supervision of non-bank finance.
  - Upgrade the energy sector: address high energy costs (Baltic countries face among the highest energy costs in Europe when adjusted for purchasing power); reduce dependence on Russia; build interconnections (examples noted: Lithuania secured alternatives; Estonia built large-capacity connections to Finland).
  - Invest in common infrastructure: modern shared infrastructure to reduce transport costs and improve connectivity with Central and Western Europe.
  - Harmonize rules and practices: disclosure and accounting rules, licensing, recognition of foreign degrees, and procedures for hiring non-EU workers to improve FDI attractiveness.
  - Coordinate labor market taxation to avoid uneven playing fields when shifting taxes away from labor.
  - Enhance policy dialogue and regional fora (including Nordic partners) to share lessons on education, training, and tackling high unemployment.

### Authorities’ views and reservations
- Broad agreement with national and regional recommendations, with caveats:
  - Few direct levers to influence credit supply given dominant Nordic banks; requests for more detailed advice on differing insolvency regimes.
  - Active steps underway on infrastructure and R&D improvements.
  - On taxation, Estonia favors shifting burden from labor toward consumption; Latvia and Lithuania moving similarly.
  - Emphasis on ALMPs quality; vocational training highlighted by Latvian authorities.
  - Authorities see merit in coordination but are cautious that tax reductions may not always yield net benefits.

### Staff appraisal — summary findings and priorities
- Baltic economies performed well over two decades relative to other transition economies and emerging markets.
- Economic policy features: prudent fiscal policies, low inflation via exchange rate-based stabilizations, and free-market regulatory approaches akin to Nordic and Anglo-Saxon countries.
- Common challenges (creditless recovery, export headwinds, structural unemployment) warrant both national and regional policy responses.
- Key priorities:
  - Revive credit growth to sustain investment and income convergence; improve insolvency regimes (especially in Latvia and Lithuania) and explore deepening non-bank finance over the medium term.
  - Maintain competitiveness and pursue product upgrading in exports while addressing demographic and trading-partner growth headwinds.
  - Reduce structural unemployment via tax-wedge adjustments (fiscally-neutral where possible), improved education and ALMPs, and reductions in benefit disincentives.
  - Collective action to improve infrastructure links with the EU, particularly in energy and rail.

*Source: BALTIC CLUSTER REPORT, INTERNATIONAL MONETARY FUND (content unit: _cr14116).*

### INTRODUCTION __________________________________________________________________________________  3

### _cr14116 - INTRODUCTION

### Purpose and scope
- Examines common themes and challenges facing the three Baltic countries—Estonia, Latvia, and Lithuania (henceforth the Baltics).
- Aims to identify common features (including the Baltics’ revealed preference of economic model), common challenges, and national and joint policies to address them.
- Complements and provides background for issues discussed in the individual Article IV consultations for each Baltic country.

### Performance overview and recovery dynamics
- The Baltics have performed well over the last two decades, with income convergence to advanced economies that follow similar economic models (e.g., the Nordics and the “Anglo-Saxons”) more rapid than in transition economy or emerging market peers.
- Pre-crisis boom indicators (by 2007): annual credit growth reached an average of 36 percent; current account deficits soared to 18 percent of GDP; inflation rose to 10 percent; bank loan-to-deposit ratios exceeded 200 percent.
- After deep recessions in 2009, recovery featured:
  - Fast GDP growth by 2011 (fastest in the EU).
  - Export-led recovery reflecting competitiveness improvements.
  - Unwinding of imbalances: current account deficits near balance, bank loan-to-deposit ratios reduced considerably, low inflation, and declines in household and corporate debt.

### Main shared challenges to sustaining growth
- Identified focus areas for sustaining robust growth (especially as members of the euro area):
  - Resuscitating credit growth: reversing the “creditless recovery.”
  - Securing a vibrant export sector: building on strong post-crisis export performance.
  - Addressing high unemployment: unlocking the labor force’s full potential.
- Policy action required at national level for all challenges; regional collaboration important or essential in certain areas (e.g., infrastructure supporting exports).

### The Baltic economic model: characteristics
- Small, highly open economies with strong links to the Nordics and to each other.
- Financial sectors among the most open globally; high levels of FDI and trade.
- Banking systems dominated by Nordic-headquartered banks; reliance on parent bank funding high but declining fast.
- Non-bank financial sector relatively undeveloped.
- Broad macroeconomic model features:
  - Small government: low government expenditure-to-GDP ratios; light taxation on income, capital, and wealth; relatively high social security contributions (labor taxes).
  - Prudent public finances: public debt around 30 percent of GDP for the region and well below advanced and emerging economy comparators.
  - Limited monetary policy tools: currency board arrangements historically anchored inflation; Estonia and Latvia have adopted the euro; Lithuania applying to do so in 2015.
  - Relatively favorable investment climate: good business climate indicators; labor markets flexible and more aligned with the laissez-faire Anglo-Saxon model rather than the Nordic “flexicurity” model.
  - Moderately high income inequality: moderate redistribution; Gini coefficients higher than the Nordics, similar to Anglo-Saxons, lower than some emerging OECD economies.

### Income convergence
- Substantial progress over two decades:
  - Starting from income levels of around ten percent of Nordic and Anglo-Saxon countries in 1995, the Baltics have tripled their income levels as a share of Nordic and Anglo-Saxon per capita GDP by 2013.
  - Baltics have surpassed income levels of the CE4 and emerging OECD economies.

### Resuscitating credit growth: current situation and drivers
- All three Baltics experienced a creditless recovery:
  - Post-crisis, despite strong economic turnaround and rebalancing, credit was still declining in Latvia and Lithuania and weak in Estonia.
  - Private debt-to-GDP ratios have declined considerably but remain elevated relative to pre-boom levels.
- Empirical context:
  - Creditless recoveries commonly follow rapid credit expansions and sharp corrections; the Baltics’ boom-bust cycle was steeper-than-average, possibly implying a longer-than-average period of negative credit growth. However, historical experience suggests credit growth should resume around this stage of recovery.
- Drivers across phases:
  - Boom: Domestic demand was a key driver. Non-financial private sector credit peaks:
    - 110 percent of GDP in Estonia and Latvia (from 30 and 40 percent of GDP six years earlier, respectively).
    - 70 percent of GDP in Lithuania (from 20 percent of GDP six years earlier).
  - Recession: Credit supply factors dominated. Deteriorating bank asset quality strongly associated with credit contraction.
  - Recovery: Both demand and supply factors matter. Lending standards tightened during the recession have not been substantially relaxed during recovery in Latvia and Lithuania. NPLs have declined but remain high.
- Cross-country variation:
  - Estonia: supply factors less important; bank balance sheets healthier; much lower NPL ratios; real credit contraction has ceased but remains weak.
  - Latvia and Lithuania: real credit continues to contract; lending standards remain relatively tight.
- Non-bank finance and integration:
  - Non-bank financial alternatives (capital markets, stock market capitalization, venture capital) are small; banking remains dominant.
  - Progress in financial integration among the Baltics and with the Nordics (shared trading platform, coordinated regulations and supervision) aids access to broader investor pools, but short-run credit revival depends on the banking system.

*Source: INTRODUCTION, BALTIC CLUSTER REPORT (IMF).*

### 17.      The authorities agreed that low credit growth was an issue facing their countries,

### _cr14116 - 17.      The authorities agreed that low credit growth was an issue facing their countries,

### Credit growth and financial conditions
- Low credit growth identified as an issue; views differed on causes:
  - Estonia: weak credit growth attributed to poor demand for credit—weak investment activity, high retained earnings, and weak external demand. Noted that credit in Estonia is growing, in contrast to the other two Baltic countries.
  - Latvia and Lithuania: saw credit supply constraints as an important factor alongside demand factors; concurred with staff that anecdotal evidence supported this view.
- Key observations from staff analysis and charts:
  - "Credit growth remained negative, despite strong GDP recoveries."
  - Historically, creditless recoveries have been associated with lower GDP growth and have affected EMs more than AEs.
  - Parent bank funding shrank and asset quality deteriorated, making banks more cautious.
  - The debt overhang has not been fully resolved in the Baltics.
  - Baltic credit-to-GDP ratio comparisons shown against Finland, Sweden, and EMs (figures displayed).

### Non-bank financial market structure
- Non-bank financial markets are under-developed in the Baltics, in line with their relatively low GDP per capita.
- Charts highlight Bonds and Stocks (pct. of GDP) and GDP per Capita (EUR) comparisons across countries.

### Export performance: recent achievements
- Since 2000:
  - Latvian exporters increased world market shares by 100 percent.
  - Lithuanian exporters increased world market shares by 150 percent.
  - Estonia increased world market shares by 70 percent (having secured a very strong position prior to 2000).
- Other export performance highlights:
  - Market share gains were broad-based for Latvian and Lithuanian exporters; more confined to the Nordics and the United States for Estonia.
  - Increases in the export-to-GDP ratio, especially in the post-crisis period, were described as impressive.
  - During 2008–12, 35–45 percent of Baltic exports comprised products in markets that expanded relatively strongly at the global level.
  - A fair proportion of Baltic exports is concentrated in globally dynamic product categories, and Baltic exporters managed to gain market share in most of them.
- Competitiveness and export drivers:
  - Improved price competitiveness: a combination of wage restraint and productivity advances in the post-crisis period reduced Baltic unit labor costs by 10 to 20 percent relative to western European competitors.
  - Diverse trading partners: EU as a whole most important since mid-1990s; increased intra-Baltic and Central Eastern and Southeastern Europe trade; Nordics consistently important (Estonia with a share of around 40 percent).
  - Services exports important: external services accounts in surplus for all three countries; sophisticated services (ICT, "other business services") play an important role particularly in Estonia.

### FDI and Global Value Chains (GVCs)
- FDI:
  - Estonia’s FDI stock (at about 80 percent of GDP) is roughly twice that of Latvia and Lithuania, but all are still above the global median.
  - Swedish companies are the most important foreign direct investors in all three countries; Finland is second for Estonia, the Netherlands for Latvia, and Poland for Lithuania.
- GVC participation:
  - According to the GVC participation index, Latvia and Lithuania are linked up as much as the global average, while Estonia has substantially higher participation.
  - All three Baltic economies are considerably less involved in GVCs than the CE4.

### Export challenges and vulnerabilities
- Signs of slowing and vulnerabilities:
  - Export volume growth has come down sharply from the double-digit rates achieved in the early years of the post-crisis recovery phase.
  - The Baltics have been less successful in attracting FDI in recent years—their share of global FDI declined from about 0.4 percent during 2005–07 to about 0.2 percent during 2010–12.
- Structural concerns:
  - Quality of exports: the bulk of the quality catch-up for the existing product mix has broadly evolved in line with global trends and has not improved faster than global markets; future gains depend on shifting to new products and enhancing non-price competitiveness.
  - Export sophistication: revealed comparative advantage remains in labor-intensive goods and services; Estonia has some advantage in knowledge-intensive services; high and medium-to-high technology goods account for a relatively low share of Baltic exports compared to the CE4 and the euro area.
  - Lower trading-partner growth: WEO projections indicate trading partner import growth for the Baltics is projected to decline substantially and fall below global trade growth.
  - Adverse demographics: demographic aging and collapsed birth rates from early transition represent a key challenge for labor supply and the ability to attract FDI; this is especially problematic for economies specialized in labor-intensive goods and services.

### Authorities’ views on exports
- Authorities agreed that future export success cannot be taken for granted but were confident in meeting the challenge.
- Key authority positions:
  - Demographic aging and potentially lower trading partner growth are serious issues.
  - There is room to further benefit from ongoing upgrading of the export product mix; income convergence will naturally shift away from labor-intensive products.
  - Exports are based on small, nimble firms operating in niche markets—an alternative successful strategy to deep GVC integration.
  - Exports have become significantly more sophisticated and diversified over time.

### Unemployment: scope and structural nature
- Current levels and characteristics:
  - Unemployment has fallen significantly from its post-crisis peak but remains in the 8–12 percent range.
  - Youth unemployment is particularly high; about half the unemployed have been out of a job for more than one year.
- NAIRU and structural findings:
  - Staff estimates: the NAIRU in the Baltics is high, stable, and close to current unemployment.
    - For Lithuania and Latvia, the time-varying point estimate ranges between 10 and 13¾ percent.
    - For Estonia, it ranges between 11½ and 16½ percent.
  - Current unemployment levels are close to estimated NAIRU (in 2013) for Latvia and Lithuania, and somewhat below estimated NAIRU (in 2013) for Estonia.
  - Implication: with output growing at potential, unemployment would not drop significantly without rising wage and inflationary pressures.
- Robustness checks supporting structural unemployment:
  - NAIRU estimates align with historical average unemployment.
  - Real wage behavior: real wage growth accelerates when unemployment falls below the NAIRU.
  - Beveridge curve and Okun’s Law coefficient have remained stable over time.
  - Staff NAIRU estimates broadly in line with other international organizations.

### Labor market institutions, tax wedges, and traps
- Labor market flexibility:
  - Minimum wages, as a share of mean wage, are below or close to the OECD average.
  - Unemployment benefits are much less generous than OECD average, providing strong monetary incentives to seek work.
  - Employment protection is in line with the OECD average.
- Tax wedges and disincentives:
  - High labor tax wedges could contribute to high structural unemployment by depressing labor supply and expanding the shadow economy.
  - Reductions in the tax wedge are associated with declines in structural unemployment in cross-country and event studies.
- Unemployment and inactivity traps:
  - High taxes on labor combined with loss of social/unemployment benefits upon employment decrease attractiveness of participating in the labor market, especially for lower-wage earners.
  - The unemployment and inactivity trap measures are generally higher in the Baltics than in the CE4, the Anglo-Saxons, and other emerging OECD countries (charts provided).
- Skills mismatches and ALMPs:
  - Skill mismatches are important amid mixed education outcomes; all three Baltics score worse than average on skill mismatch.
  - Regional divides: e.g., Lithuania’s rural unemployment is much higher and concentrated among workers with below-tertiary education.
  - Spending on active labor market policies (ALMPs):
    - Baltics: 0.5 percent of GDP spent on ALMPs.
    - Nordics: over 2 percent of GDP spent on ALMPs.
    - Of Baltic ALMP spending, only 0.1 percent of GDP was spent on training—less than half that in the Nordics.
  - Passive forms of labor market support (out-of-work income benefits and, in Latvia and Lithuania, early retirement) account for a significant share of total ALMP spending in the Baltics.
  - Low ALMP spending reflects very low participation in these programs rather than high efficiency; longer-term averages of unemployment (especially for youth) show a negative correlation with spending on ALMPs, indicating their potential in addressing skill mismatches.

*International Monetary Fund — Baltic Cluster Report (content unit: _cr14116 - 17.)*

### 32.      The authorities agreed that structural unemployment was high, although views

### _cr14116 - 32.      The authorities agreed that structural unemployment was high, although views

### Structural unemployment: diagnosis and authorities' views
- Authorities across the Baltics agreed structural unemployment was high, though disagreed on precise NAIRU level.
- Latvian and Lithuanian authorities: current unemployment levels mostly reflect structural factors.
- Estonian authorities: NAIRU probably somewhat below staff’s estimates, but still concurred structural unemployment is likely high.
- Common identified contributors:
  - Skill and education mismatches.
  - Tax wedge concerns, especially for lower-income earners.
  - Impact of opening the EU common labor market and migration effects (emphasized by Estonian and Latvian authorities).

### Policy agenda — overarching priorities
- Continued structural reforms needed to address challenges from a rapidly changing global economy, euro area membership, and demographic trends.
- National policies should be primary, but joint action and coordination across the three countries can help.

### A. National policies to address challenges — findings and recommendations
- Credit growth and insolvency:
  - Debt ratios remain well above pre-boom levels despite substantial deleveraging since the crisis.
  - Strengthening insolvency frameworks is important; further improvements in administration could facilitate restructuring and resolution of household and corporate debt.
  - Suggested measures: fast-tracking legal system to clear cases, improving implementation of existing procedures, exploring arbitration/mediation to reduce caseload on regular courts.
  - Note: Baltics may have few direct levers to improve credit supply due to the large presence of foreign banks.
- Export sector, FDI, and competitiveness:
  - Maintain post-crisis competitiveness by aligning wage growth with productivity gains; productivity expansion requires firm entry and investment supported by credit expansion.
  - Address barriers in product and services markets to encourage expansion into higher-skill markets.
  - Integrate into global supply chains and attract FDI; policy recommendations on skills will support FDI attraction.
  - Rankings cited: World Bank 2014 Doing Business (Baltics ranked among the best); IMD World Competitiveness Report (region dragged down by R&D limitations except Estonia, and inefficiencies in legal environment and public services); WEF Global Enabling Trade Report (2012) (above average overall but shortcomings in services, infrastructure, hiring foreign labor, and trade financing).
- Employment policies to reduce structural unemployment:
  - Reconsider labor taxation: cross-country experience links reductions in the tax wedge to declines in structural unemployment, but Baltic revenue-to-GDP ratios are already low; options include increasing taxation on capital and wealth, base broadening, and improvements in revenue administration; consider coordinated adjustments across countries.
  - Improve education outcomes: better coordination between universities and employers and quality improvements in secondary education, particularly in Latvia and Lithuania; given small size, Baltics may need to exceed other countries' educational outcomes to attract FDI.
  - Increase spending and participation in ALMPs (Active Labor Market Policies): scope to reduce skill mismatches; draw lessons from Nordic experience; use available EU funds to support ALMPs.
  - Review disincentives in benefits systems: investigate possible “benefits traps” and tax incentives in rural/agricultural activities that may sustain informal employment and high rural unemployment (noted at least in Lithuania).

### Authorities’ national-policy responses and reservations
- General agreement with national policy recommendations, with reservations:
  - On credit growth: few direct levers to influence credit supply by mainly Nordic banks; Latvian and Lithuanian authorities requested more detailed advice as differing insolvency regimes have not yielded notable differences in credit dynamics.
  - On trade and FDI: authorities are taking actions to improve infrastructure links and the R&D environment.
  - On unemployment: authorities acknowledge high labor taxes; Estonia favors shifting tax burden from labor toward consumption; Latvia and Lithuania are also working in this direction.
  - Emphasis on ALMPs quality (not just quantity); Latvian authorities highlighted vocational training.

### B. Joint action — regional measures to boost resilience
- Rationale: small size and similarities across the Baltics justify integration, harmonization, and collaboration to achieve economies of scale.
- Recommended joint/regional actions:
  - Develop the non-bank financial sector: facilitate cross-border investment, lower financing costs; harmonize regulatory requirements (accounting, tax); consider alternative exchanges, regional ratings agencies, securitization, credit guarantee systems, and fostering institutional investors; ensure strengthened supervision of the non-bank financial sector.
  - Upgrade the energy sector: address high energy costs (Baltic countries face among the highest energy costs in Europe when adjusted for purchasing power); reduce dependence on Russia; note Lithuania has secured alternative options, Estonia built large-capacity electricity connections to Finland; joint projects can exploit economies of scale.
  - Invest in common infrastructure: modern, shared infrastructure to reduce transport costs, improve transshipment connectivity, and advance integration with Central and Western Europe.
  - Harmonize rules and practices: disclosure and accounting rules, licensing procedures, recognition of foreign degrees and qualifications, and procedures for hiring non-EU workers to enhance FDI attractiveness and regional economic integration.
  - Coordinate labor market taxation: coordination could avoid uneven playing fields if re-orienting taxes away from labor.
  - Enhance policy dialogue: regional fora (including Nordic partners) to share lessons on education, training, and tackling high unemployment.

### Authorities’ views on joint action
- Broad agreement on merits of coordination among Baltic states and within the Nordic-Baltic region; existing coordination considered extensive and effective.
- EU directives have already advanced harmonization significantly.
- On labor market taxation: authorities see merits in coordination but remain unconvinced benefits of tax reductions necessarily outweigh drawbacks.
- On energy and infrastructure: much work already done or at advanced stages, but additional agreement on common approaches (e.g., rail links) is needed.

### Staff appraisal — summary findings
- Baltic economies performed well over two decades relative to other transition economies and emerging markets.
- Economic policy features: prudent fiscal policies, low inflation via exchange rate-based stabilizations, and free-market regulatory approaches similar to Nordic and Anglo-Saxon countries.
- Common challenges remain; both national and regional policy responses are appropriate.
- Recovery characterized by robust growth amid contracting credit; continued anemic credit could constrain investment and growth.
  - Latvia and Lithuania: improving insolvency regimes could spur demand and supply of bank credit.
  - Estonia: lower NPL increases and faster normalization; real credit has ceased contracting.
  - Over the medium term, explore deepening non-bank finance.
- Export performance: product upgrading and export market share gains achieved; future headwinds from adverse demographic trends and likely slower trading-partner growth.
- Collective action needed to improve infrastructure links with the EU, especially for energy and rail.

*International Monetary Fund — Baltic Cluster Report*

### 47.      Finally, labor markets in the Baltics have performed well, showing considerable

### _cr14116 - 47.      Finally, labor markets in the Baltics have performed well, showing considerable

### Labor market performance and characterization
- Labor markets in the Baltics "have performed well, showing considerable resilience and flexibility during the crisis."
- "Wage flexibility undoubtedly cushioned the impact of the very severe recessions on employment and helped speed the recovery."
- Despite this, "the Baltics appear to be at or near full structural employment even though unemployment rates are just above or just below 10 percent."
- Staff estimates suggest much of the current unemployment is "structural in nature."
- The authorities note a marked improvement in headline unemployment: "swift decline of the headline unemployment (from close to 20 percent during the peak of the crisis to close to 10 percent at present)."

### Key constraints: structural unemployment, tax wedge, and skills mismatches
- Structural unemployment is a significant concern; estimates (including NAIRU-based estimates) have "uncertainty" but point to high structural unemployment.
- Labor taxation: "Labor tax wedges are high in the Baltics, particularly for low-wage workers."
- Skills and education: "skill and education mismatch" is identified as a driver of structural unemployment and lower labor utilization.
- Active labor market policies (ALMPs): "While there have been recent increases in spending on active labor market policies, there appears to be considerable scope to reduce skills mismatches and improve productivity through training and education."

### Policy recommendations on labor and skills
- Reduce the labor tax wedge, "particularly for low-wage workers," but do so "in the context of fiscally-neutral tax reforms" (i.e., shifts in tax structure that retain the revenue envelope).
- Increase emphasis on education, training, and other active labor market policies to address skill mismatches.
- When expanding ALMPs, prioritize not only the quantity of spending but also the quality of measures.
- Explore a "shift of taxation away from labor (with appropriate compensatory measures to retain the revenue envelope)."

### Credit, recovery, and financing
- The Baltic recoveries have been "creditless recoveries"; recoveries so far "largely creditless" with credit lagging other episodes of creditless recoveries.
- Reviving credit growth is characterized as "essential to sustain economic growth, and, in the longer term, foster income convergence."
- Directors encouraged reforms to improve credit supply and banks' risk perception:
  - Improve insolvency regimes to address remaining debt overhang and improve banks’ risk perception.
  - Explore deepening non-bank sources of financing, including "alternative exchanges with less stringent reporting requirements, regional ratings agencies, and securitization."
- The authorities emphasize both supply and demand factors in subdued credit growth and note cross-country differences (Estonia slightly ahead; in Estonia "supply constraints have dissipated and the modest credit growth hinges on the demand side").

### Exports, competitiveness, and upgrading
- Exports have been a key feature of the post-crisis recovery: "success in increasing exports" and "strong export growth has been instrumental for the post-crisis recovery."
- Export performance is supported by "improved price competitiveness" attributable to wage restraint and productivity advances that "significantly reduced Baltic unit labor costs during the crises."
- Concerns:
  - High concentration in labor-intensive goods may limit future export gains, especially given adverse demographics.
  - Questions about how well positioned the Baltics are to extend their export performance and "to increase the exposure of Baltic exports to globally dynamic and sophisticated product categories."
- Authorities' counterpoints:
  - They argue export quality catch-up has been ongoing and that declining unit values (UVs) can also signal "improved price competitiveness."
  - They see "strong potential for further export sophistication in the medium term" and note Baltic movement "upstream" in global value chains (GVCs).
- Policy emphasis: preserve competitiveness, upgrade labor force skills, improve labor force utilization, invest in infrastructure, and further capitalize on a favorable business environment.

### Regional cooperation and structural reforms
- Directors and authorities support greater regional cooperation to address common challenges, including:
  - Upgrading the energy sector and exploring alternative energy options.
  - Investing in transportation infrastructure to reduce costs.
  - Developing the non-bank financial sector.
- The authorities note much of the work should remain at the national level but see merit in closer regional cooperation and harmonization through the EU context.

### Governance of the cluster approach
- The Baltic Cluster Report is part of an IMF pilot project on clustering Article IV consultations to analyze logical groups of economies in an integrated way.
- The authorities view the clustered analysis as valuable for cross-country comparisons and policy dialogue, and suggest exploring broader cluster selection, including thematic or combined Nordic-Baltic cluster approaches.

*Source: BALTIC CLUSTER REPORT, INTERNATIONAL MONETARY FUND*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14116.pdf_