Credit Crunch Could Cool Hot Baltics

It's strange to say it, but the U.S. credit crisis might be just the bitter pill the Baltics needed.

For years economists have warned that the super-charged economies of Latvia, Lithuania, and Estonia were in danger of overheating and needed to retreat from the red line. Robust consumer spending, however, has continued driving growth and, with it, inflation, which reached a staggering 14.1 percent in Latvia last year.

Baltic governments haven't been able to leash their economies partially because they've lacked the fiscal discipline to reduce public spending but also because their currencies are pegged to the euro as the initial step in eurozone accession. As a result, they don't have the independent monetary policy to combat consumer spending and inflation through interest rate hikes, for instance.

But the evident global economic slowdown triggered by the U.S. subprime mortgage meltdown looks to have hastened the cooling process economists have been begging for.

Indeed, there are signs of a tipping point in the Baltics. Lithuania posted its first quarterly economic contraction since 2001 at the end of last year, and year-end growth was more than a percentage point below the government's 10 percent forecast. In December, retail trade in Latvia decreased 2.6 percent, the biggest drop in the European Union, and manufacturing output fell into the red in Estonia.

JPMorgan Chase & Co. has predicted the trio's average growth could fall to 5 percent in 2008. This represents a significant slowdown from the high single-digit figures of the past half-decade, one at least a healthy portion of the international economic community applauds.

JITTERY FOREIGNERS

"We should welcome some amount of a slowdown, especially in the Baltic states, which have been growing the fastest," Leszek Balcerowicz, former governor of the Polish central bank, said earlier this month.

Christoph Rosenberg, head of the International Monetary Fund’s Central Europe and Baltics office, echoed Balcerowicz's message.

The Baltics "have been vulnerable for quite some time. The whole overheating story, we've been talking about this for years and years, and it's been getting worse," he said. "In an awkward way, the global credit crunch is good for them because it helps engineer" the necessary slowdown.

Just how sharp the deceleration will be remains a big question mark, and it's important to note that some observers fear a hard landing, or an economy that plunges straight from growth into recession.

Many economists are particularly nervous about the Baltics' hefty current account deficits, which are being financed by foreign banks. Latvia's is the highest, at nearly 25 percent of GDP.

In a November report on Europe, the IMF said that countries funding large current account deficits with foreign currency could be particularly vulnerable to the reverberations of the credit crunch as lenders become more reluctant to write checks.

Investors are already starting to cut back in the Baltics. The Swedish banks that have been paying their current account bills have reduced lending from 60 percent annual growth to 25 percent.

Foreign money could be further shaken by the reality that soaring inflation well above the EU's limits for adopting the euro has made joining the currency union anytime soon a pipedream in Latvia, Lithuania, and Estonia.

In October, European Central Bank board member Jurgen Stark said the post-Soviet countries faced "significant challenges" to joining the eurozone, a statement The Economist deciphered as "banker speak for 'forget it.' "

The longer euro adoption takes, the edgier investors are likely to become. Eurozone accession brings with it a legitimacy that attracts foreign money and eases access to capital. Today investors are at least partly bullish on the Baltics because they believe EU integration will continue with eurozone accession, but they could start putting away their checkbooks if there's a perceived cooling on the euro.

In the worst case, a sharp decline in investor confidence could spark a precipitous currency devaluation that would drop the Baltics into recession. This is a possibility, but most observers agree a hard landing will be parried. Growth will slow, credit defaults will increase, but recession is unlikely.

The IMF and others are encouraging Baltic governments to implement policies that will safely continue the incipient cooling process. First among them is a reduction in public spending. Many economists would like to see Latvia's budget surplus at a minimum of 3 percent of GDP, a much higher figure than the 1 percent planned for this year.

Baltic leaders are signaling a receptive ear, with Latvia planning to increase its surplus to 1.5 percent of GDP by 2010. But many observers would welcome a greater sense of urgency, especially in Lithuania, where perceived budget laxity prompted Standard and Poor's to downgrade the country's currency ratings last month from A to A-.

Baltic governments would be wise to get serious on the tough measures, such as spending cuts, necessary to stabilize their economies. Because while not only are the evident upsides of the slowing world economy temporary, but the ultimate extent of the fallout from the U.S. credit crisis remains unclear.

For the Baltics, as for many other European economies over the next couple of years, that pill could become a lot more difficult to swallow.