Toughing It Out: How the Baltics Defied Predictions

IMF Blog, January 7, 2011

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Author: Christoph Rosenberg
Date: January 7, 2011
Core claim: Estonia, Latvia, and Lithuania opted to maintain currency pegs against the euro during the 2008–09 crisis and adjusted via “internal devaluation” (budget and wage cuts, supported by financial and structural reforms) rather than devaluation.
Context: After a boom with “Chinese-style growth rates,” the Baltics experienced a severe bust: credit, property prices, consumption, and investment collapsed; exports fell; the financial sector came under severe stress.
IMF support: The IMF supported Latvia with a €1.7 billion loan as part of an international rescue package of €7.5 billion.

Cumulative GDP contraction: “about a quarter.”
Avoided outcomes (contrary to conventional wisdom at the time):
- Devaluation of the currencies.
- Banking crises of the most extreme predicted form (while banking systems faced severe stress, the most dire predictions did not materialize).
Recent trajectory: All three countries have recently started growing again, helped by a pick-up in external demand.
Euro adoption milestone: Estonia became the 17th member of the euro area on January 1, 2011.

Structural flexibility:
- Economic structures transformed over two decades proved relatively flexible.
- Early evidence suggests companies and workers adapted quickly to the post-boom environment.
Market structure and speculative resistance:
- Small foreign currency markets, dominated by a few domestic players, made it virtually impossible for outsiders to take speculative positions against the three currencies.
Regional banking ties:
- Close integration with Nordic neighbors and significant foreign bank ownership added stability.
- Deep-pocketed parent banks, backstopped by their home country governments, were willing and able to absorb losses rather than pulling out.
Fiscal and social responses:
- Fiscal belt-tightening, including wage, pension, and social benefit reductions, was broadly supported by the population.
- Public determination rooted in strong social cohesion and the desire to maintain stability and eventually adopt the euro.

Latvia:
- Suffered the deepest crisis, “probably because imbalances during the boom were the largest there.”
- Banking system partly domestically owned and particularly vulnerable to sudden stops and capital outflows.
Estonia:
- Contained pressures on public finances and the financial system better than neighbors.
- Factors behind Estonia’s stronger position and euro adoption:
- Timing — the recession started earlier and the government moved quickly to adjust policies.
- Institutions — sizeable fiscal reserves built during the boom and a tradition of strong tax compliance.
- Banking ownership — a fully foreign-owned banking system whose banks received strong capital and liquidity support from abroad, further boosted by a precautionary swap line between Swedish and Estonian central banks.
Lithuania:
- Experienced a delayed (and smaller) boom, which “may now make it easier to regain competitiveness.”

Persistent problems:
- Unemployment remains high.
- Public finances still pose a challenge.
- Competitiveness needs a further boost.
- The banking system is still being repaired.
Cautionary note: Adjustment is still far from complete, and problems in the eurozone may complicate recovery.

Large economic adjustment including nominal wage and benefit cuts is possible under a currency peg (or in a currency union) given:
- Grit (political and social determination).
- Flexibility in economic structures.
- Supportive external banking ties and prudent fiscal/institutional buffers.
Prudent policies during booms:
- May not prevent a bust, but can place countries in a better position to deal with shocks, as illustrated by Estonia.

Source: Toughing It Out: How the Baltics Defied Predictions — Christoph Rosenberg, January 7, 2011.