The Economic and Financial Development
of the Baltic States

by Louise Andersen and Kristian Kjeldsen, International Department

Introduction

The Baltic states are currently experiencing strong economic growth after the slowdown following on their independence at the beginning of the 1990s. Likewise, the financial sectors of all three countries are undergoing rapid and predominantly healthy development after the banking crises earlier in the 1990s. As for other emerging markets the strong economic growth is accompanied by large current-account deficits related to the considerable growth in the countries' investments.

The financing of substantial deficits on the current account of the balance of payments requires the countries to conduct a stable economic policy and to have a healthy financial sector, subject to effective supervision. The economic policy of the Baltic states is maintaining this course, and this has created the necessary confidence among foreign investors who finance a large proportion of the current-account deficits via investments and lending. Despite the substantial current-account deficits the Baltic states are therefore in structural and institutional terms in a relatively favourable position. A contributing factor is the implementation of extensive stability-oriented economic programmes supported by the IMF.

Macroeconomic development

In the period immediately after the collapse of the Soviet Union all three countries experienced a strong drop in output measured by real GDP. It was only as from 1996 that real GDP growth really became positive, cf. Chart 1.

In Estonia growth in real GDP reached 10 per cent in 1997, primarily as a consequence of strong growth in private consumption, private investments and exports. In Latvia and Lithuania growth was also broadbased, with considerable growth in investments. In 1997 real GDP rose by approximately 6 per cent in both Latvia and Lithuania.

GDP per capita in 1997 has been compiled provisionally at $3,200 in Estonia, $2,200 in Latvia and $2,500 in Lithuania. For comparison, Denmark's GDP per capita is approximately $30,000, while GDP is approximately $10,000 in Portugal, which had the lowest GDP per capita in the

EU in 1997.¹⁾ However, measured by purchasing-power-adjusted GDP per capita the differences will be smaller.²⁾

The three countries' greatest economic problem today is their current-account deficits. These deficits are a natural consequence of the major structural changes which the countries are currently undergoing in conjunction with the rebuilding of the capital stock. The strong domestic demand has entailed that imports have increased considerably more than exports. Estonia's current-account deficit was approximately 13 per cent of GDP in 1997 as a consequence of a trade deficit of approximately 25 per cent³⁾ and a service-balance surplus of approximately 12 per cent. In Lithuania the current-account deficit also exceeded 10 per cent in 1997, while in Latvia it was almost 7 per cent, cf. Chart 2.

The major current-account deficits entail that the countries expose themselves to a considerable risk with regard to non-residents' continued willingness to invest. Since the current-account deficit must be financed by an equivalent capital-account surplus the countries are strongly dependent on foreign investments and opportunities to borrow abroad.

If the capital-account items consist mainly of short-term loans or portfolio investments which can be quickly withdrawn, the countries' risk will be further increased compared to a situation where capital inflows consist of medium- or long-term loans and Foreign Direct Investments, (FDI). Estonia is the country with the largest proportion of portfolio investments and this share has been increasing in recent years, while on the other hand the proportion of FDI has been falling since 1994. In Latvia and Lithuania the volume of FDI has been rising significantly, while portfolio investments are modest. FDI as a proportion of GDP was 2.8 per cent in Estonia in 1997, 7.6 per cent in Latvia and 3.6 per cent in Lithuania.⁴⁾ It should be stated that FDI are not necessarily long-term investments and since the figures are subject to data uncertainty and major fluctuations from year to year, partly due to privatization, they should be interpreted with great caution.

The ratio between total foreign-exchange reserves and monthly current-account expenditure can be taken as an indicator of whether the countries' foreign-exchange reserves match the continuously growing current-account deficits. It is normally considered appropriate that the foreign-exchange reserves are on average equivalent to approximately three months' current-account expenditure (or merely import expenditure). Measured by this rule of thumb the countries' reserves appear to be slightly less than appropriate, cf. Table 1.

The high inflow of capital to the countries as a consequence of the financing of the current-account deficits means that the economic policy must have a contractive effect in order to counter overheating and inflation. The greater the proportion of capital imports devoted to consumption rather than investments, the more important it is to pursue a contractive economic policy and for excess liquidity to be absorbed by e.g. issuing government bonds. Even though the general-government finances of the Baltic states would appear to be sound measured in EU terms, a tighter fiscal policy is an effective means to dampen consumption, since it is extremely difficult to influence the private sector's savings behaviour directly. As Chart 3 shows, the general-government budgets in the three countries have clearly improved since the mid-1990s. Both Estonia and Latvia thus showed a surplus on their general-government budgets in 1997.

The positive development in the general-government budgets is the result of tight management of general-government expenditure and moreover also increasing revenues as a consequence of higher GDP growth in 1996 and 1997 and a falling level of interest rates. In Latvia a further reason for the budgetary improvement is more efficient tax collection, while Lithuania raised a number of VAT rates in 1997.

Inflation has clearly declined in all years, but from a high starting level. The countries have thus moved from average annual consumer-price increases of around 200 per cent in 1991 to 11 per cent in Estonia, 8 per cent in Latvia and 9 per cent in Lithuania in 1997, cf. Table 2 (the EU average

was 1.7 per cent in 1997 measured by the harmonized index of consumer prices). In recent years inflation has tended to stagnate at around 10 per cent without declining further, which is a familiar problem for a number of other countries which previously had very high inflation rates. The consumer-price increases for recent years are e.g. attributable to major price increases for price-regulated goods such as housing, electricity, water and heating, which were previously subsidized.

The development in wages has adhered to the general decline in price development, although in some years there have been strong increases in real wages in certain sectors.

A significant factor behind the relatively speedy reduction of inflation is the countries' consistent fixed-exchange-rate policy, cf. Table 3. Estonia uses a "currency board" whereby the circulation of notes and coins is covered by the country's foreign-exchange reserve.⁵⁾ This guarantees conversion of the Estonian kroon to D-mark, which is the anchor currency. Lithuania has chosen to switch gradually from the present "currency board" in US dollars to an ordinary fixed-exchange-rate policy vis-ā-vis

the euro or a basket of currencies comprising the dollar, the euro and possibly other European currencies. The switch away from the "currency board" is combined with amendments to the central-bank act to increase the independence of the central bank. Latvia pursues a fixed-exchange-rate policy vis-ā-vis SDR, but even though there has never been an official "currency board", the country's circulation of notes and coins has in reality been covered by the foreign-exchange reserves.

"to be continued on next page"

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