The Baltic Course  

Balance of payments

Have the Baltics been living beyond their capacity for a decade?

Oleg Bozhko

It works – if you have creditors, The Baltic states, especially Estonia and Latvia, have seen their balance of payments, or current account deficits grow again in recent years, meaning that Baltic residents are buying more foreign goods and services than they can earn abroad themselves.

S.Tulenev, Chas

For example, in eight months of this year Latvian residents spent abroad 388 million US dollars more than they earned themselves (for Lithuanians and Estonians the difference was USD 520 million) and the trend has been lasting for almost ten years already. The lion’s share of the current account deficit is made up by the foreign trade deficit which this year will definitely top one billion US dollars in all of the Baltic states (see table).  

Thus Baltic residents are certainly living beyond their means, encouraged also by “hard” national currency rates pegged to the euro, in cases of Estonia and Lithuania. This practice artificially turned off an important economic “safety fuse” because a national currency rate indirectly reflects the competitive ability of the national economy: if its goods and services are in good demand on the world market, the national currency rate goes up and vice versa.  

Who are these creditors that let the Baltic residents think their national currencies are just as hard as the main world currencies? First of all, they are foreign investors making foreign direct investments (FDIs) into a country, i.e., contributing 10-100 percent to the capital of Baltic companies. Contrary to portfolio investments (with contributions under 10 percent of the capital) based on speculative motives, FDIs are long-term investments regarded as reliable in the sense that these investments will not “run off” at the first sign of a worsening economic situation in the country.  

This year FDIs cover nearly 110 percent of the current account deficit in Lithuania, 82 percent in Latvia and 33 percent in Estonia. It should be noted that in previous years Estonia led the Baltic states by amount of current account deficit covered by FDIs. The ratio of the current account deficit against GDP in the first half of 2002 was 12.5 percent in Estonia and 6.6 percent in Latvia and Lithuania (see graph). The International Monetary Fund (IMF) keeps pointing out a high current account deficit as the key risk factor for the Baltic states.  



To explain the situation in a more descriptive manner, let us imagine that one has to create working conditions for one’s personnel in a vacant plot. Of course, you can have a production facility built at top speed, but it will take a lot of time and money any way. You will need much less time and money to put up an inflatable construction kept up by excess pressure within.  

But the pumps creating pressure that supports the entire construction belong to your neighbor. He did lend them to you free of charge but said he may take them away should he need the pumps himself. There is also a container of compressed air to fall back on if the pumping equipment breaks down and has to be repaired.

For greater analogy, let us presume that the neighbor has a hangar he intends to complete with time so that it would also provide a roof to the inflatable construction which would then become redundant.  

In this case the inflatable construction stands for economy of the Baltic states, the compressed air container for foreign currency reserves of their central banks and the hangar is the European Union (EU). If the pressure within the inflatable construction (i.e., influx of FDIs) starts falling, you will have to let some air out of the container (i.e., sell hard currency from central bank reserves).  

The container provides a limited supply of compressed air (foreign currency reserves will last to pay for imports during 3-3.5 months) and you will not be able to keep the inflatable construction upright for long, using only this air. By analogy, the Baltic economies will also start losing resilience if FDIs are cut off, and the national currency rates will be affected first. When central banks are no longer able to bolster their national currencies, there will be an economic downfall like we saw in Russia or Argentina.

A safe haven in the euro zone    

How realistic is that ending to the scenario? Although FDIs in the Baltic states have not been growing lately (and even fell in Estonia), the expected accession to the EU is a good incentive for foreign investors to make their investments in the new economic space while it still has prices below European levels.  

The only obstacle could be a negative vote at the referendums on EU membership next year, especially since Latvian politicians and high-ranking officials did not spare any “black paint” for drawing the EU picture during last year's election campaign. But this will delay the country’s accession to the EU only for 2-3 years and is unlikely to seriously alter the behavior of foreign investors.  

There’s another, also unlikely scenario – a global crisis brought about by the war in Iraq, should oil prices jump to USD 40 per barrel, but then it will affect all countries, not only the Baltic states.   

After accession to the EU and in 2 more years – to the euro zone, the Baltic current account deficits will be covered by all-European surplus and in general will become a problem of the EU. And it is quite likely that the Baltic economies will actually survive another 4-5 years without dropping their habit of spending more than they are earning.