The Baltic Course  

Who deserves credit for strong Latvian lat, Lithuanian litas and Estonian kroon?

By Oleg Bozhkov

As it used to be the previous years, the balance-of-payment deficit in the Baltic states has had almost no effect on the Baltic national currencies’ exchange rates. 

The current account deficit figures in the Baltic states in the first half of the year 2003 were the following: Latvia – 218 million lats (340 mln. euro), Lithuania – 1.4 billion litas (405 mln. euro), and Estonia – 3.1 billion kroons (200 mln. euro).

A life to borrow

The current account deficit – AD – indicates that citizens of a given country buy more goods and services in the world markets than they can earn themselves. The trend of “living beyond one’s means” is to a large extent encouraged by the fact that the Baltic States national currency rates are closely tight to main global currencies.

In the late 1990s Latvia managed to keep its annual current account deficit at 380 million lats but in 2001 the figure jumped to 460 million lats. In 2002 Latvia had a current account deficit of 403 million lats and in the first half of 2003 it was at 219 million lats. Account figures are always better in the second half of the year, therefore the annual deficit in 2003 can be expected around 8.5% of GDP.

Is it high or low? In comparison to most countries in the world it is high, and by current account deficit Latvia is listed among ten world countries doing most poorly. Compared to Estonia, it’s low, however, because Estonian current account deficit in the first quarter of 2003 was 22% of GDP, one of the worst rates in the world. In the second quarter, the situation in Estonia improved a little, and the first half-year current account deficit was at the level of 16.8% GDP.

Only Lithuania proudly demonstrates a downward trend of its current account deficit: 10% of GDP after 2001, 5.3% after 2002, and 3% after the first half in 2003, despite the fact that litas is still being pegged to Euro. Most probably, this is due to the fact that Lithuanian economy is relying on manufacturing industry instead of main services as it is the case with economies in Latvia and Estonia. 

What the theory says?

As the classical theory goes, the current account deficit climbs above 5% of GDP, it creates pressures on national currency and its rate of exchange goes down. If national currency has a fixed rate, it has to be devaluated.

As we can see, Estonia has exceeded this theoretical implication four times and nothing went wrong. There could be a simple explanation of this fact, i.e. foreign direct investment inflow (not creating liabilities) in the first half of 2003 has reached about 5 billion kroons, running nearly twice as high as the current account deficit (3,1 billion kroons). Thus, the flow of foreign investments covered the current account deficit with a big surplus. In Latvia and Lithuania this FDI’ flow covered from 55% to 75% of the deficit. And so it comes to the question why foreign investors act this way, do not they know the theory?

First of all, during last decade Estonia has been brandishing the image of a post-Socialist country, as a so called leader on the “right way” to market economy, and investments were flowing into the country in much greater amounts than to any other post-Soviet economy.

Secondly, Estonia’s future membership in the EU “will cover” all foreign investors’ risks in the country. One can count months until this crucial moment! And as long as those Estonian and Latvian economies can hold on even if the situation can develop by the worst of any possible scenarios.

Foreign investors not central banks provide the right answer

It is a customary belief in Latvia that the national currency lat has remained strong for more than 10 years due to the efforts of the Bank of Latvia. The central bank’s former chairman Einars Repse kept reiterating: “As long as I am in charge of the Bank of Latvia, nothing will happen to the lat”. In fact, the solid “safety cushion” propping up the hard lat is confined to foreign direct investments, covering three-fourths of Latvia’s constant current account deficit.

It was, in fact, foreign direct investment providing from 10% to 100% of the capital in local businesses that covered Latvia’s current account deficit by three-fourths or, in bad times, even up to its half. Accordingly, the national currency felt no internal pressures and the Bank of Latvia did not have to use its gold and foreign exchange reserves to keep up the lat exchange rate.

Could Latvian central bank maintain the lat flat for 12 years all on its own with comparatively small (USD 1.3 billion) foreign exchange reserves if foreign investors had not helped? Obviously, not.

The tables list the largest foreign investors, which invested their capital into Baltic companies. It is them (and others that have remained outside this list), not the central banks that deserve credit for sparing the Baltic states the fate that struck most of the former Soviet republics. The latter had to devaluate their national currencies because foreign investors did not take sufficient interest in local development.