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International Internet Magazine. Baltic States news & analytics Monday, 15.10.2018, 18:26

Economic growth and convergence in the Baltic States

Karsten Staehr, Professor of International and Public Finance Tallinn University of Technology Estonia, Baltic Rim Economies ISSUE # 3 , 06.11.2017.Print version
The Baltic states regained independence from the Soviet Union in August 1991. The years before had been marked by economic hardship, food shortages and high inflation. When the new governments set out to reform the economies and introduce market-based economic systems a key objective was therefore to support economic growth and raise living standards towards levels in Western Europe. The convergence path turned out to be more twisted and challenging than anticipated.

The early transition phase saw very large declines in output. The exact magnitudes remain unclear due to the structure of the economics changing and deficient reporting to the statistical authorities. The output declines in the early transition period were tied to the switch from planned to market-based economic systems, but also to the disruption of ties to the former trading partners, very high inflation and changing demand patterns. Reliable data are available from Eurostat, the statistics service of the EU, from 1995. That year GDP per capita PPP (i.e. adjusted for different purchasing powers or price levels in the countries) amounted to 26-30% of the level in the EU15, the 15 Western European EU members. The income gap started however to narrow in the following years, driven by rapid economic growth in the Baltic states.

 

The picture was abruptly disrupted when the Russian financial crisis broke out in 1998. As the Russian economy contracted and the value of the rouble plunged, export to Russia slumped and confidence waned. The result was economic setbacks in the Baltic states in 1999, though with some variance across the countries.

 

The slowdown after the Russian crisis was short-lived and from 2000 the Baltic states entered a period of unprecedented growth lasting until the outbreak of the global financial crisis. Over the years 2000-2007 the average annual rate of growth was 8% in Estonia, 8.5% in Latvia and 7.5% in Lithuania.

 

Commentators began referring to the three countries as the Baltic tigers, in reference to the previously successful South East Asian countries. Many factors contributed to the boom from 2000 to 2007. Consumer and investor confidence improved as negotiations about membership of the European Union and Nato progressed. Large inflows of capital from abroad meant that the Baltic households and businesses could borrow easily and at low interest rates. Meanwhile, tourism, transport and other service sectors thrived. The rapid economic growth meant that the income gap between the Baltic states and Western Europe shank rapidly. While income per capita PPP was around 30-34% of the EU15 level in 1999, it was 52-62% in 2008. Income levels were still substantially below those in neighbouring Sweden and Finland, but they were rapidly approaching those of several southern European countries.

 

The boom led to great optimism. The Estonian prime minister, Andrus Ansip, proclaimed in 2007 that Estonia would be one of the five richest countries in Europe within 15 years. The global financial crisis ended these lofty hopes.

 

The global financial crisis hit the Baltic states exceptionally hard. The output loss was around 14% in 2009 alone and Estonia and Latvia also saw large losses in in the years before or after. The Baltic states were subject to sudden stops as capital inflows ceased abruptly, making it difficult to borrow for consumption and investment. Export was severely hampered by declining foreign demand. Moreover, business confidence waned and investments collapsed. The crisis led to very high unemployment and economic hardship in turn spurring mass emigration from especially Latvia and Lithuania. The Baltic states returned to economic growth in 2010-2011 and have since had positive growth rates. Economic growth has however been relatively modest, amounting to around 2-3% per year throughout the years 2012-2016. The convergence process has slowed down and this is particularly the case if the income level of the Baltic states is compared to the one of Sweden or other western Baltic rim countries. In 2016 GDP per capita PPP was 60-71% of the EU15 level and 52-61% of the level in Sweden. The somewhat unsatisfactory growth performance following the crisis is particularly concerning given the very large output declines during the global financial crisis. Empirical analyses show that economic growth in the Baltic states in the post-crisis period can be explained almost entirely by growth in the capital stock and employment while there has been virtually no growth in the efficiency with which these resources are used. The development has led to the question whether the Baltic states may be caught in a middle income trap, i.e. a situation where income convergence ceases at the time per capita income reaches say half of the US level. Some middle-income countries in Latin America and Asia appear to have been caught in such a trap marked by low investments and slow technological advancement. The economic prospects for the Baltic states have improved in 2017, and forecasts of economic growth in 2017 and 2018 have been raised as new data have become available. The upturn is largely driven by domestic demand, in particular demand from the construction and retail sectors.

 

This panoramic account of economic developments in the Baltic states since they regained independence in 1991 has highlighted the rapid but also very volatile economic growth. Production and living standards have improved greatly, narrowing the gap to their Western European peers, including its Baltic rim neighbours Finland, Sweden and Denmark. Booms have however not been sustainable and the ensuring recessions have been exceptionally deep causing great economic hardship. Looking ahead, the goal must be to ensure high rates of economic growth and a continuation of the convergence process while at the same time seeking to reduce excessive business cycle dynamics. The economic achievements of the Baltic states in the last quarter century have been impressive but challenges remain. 






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