Baltic lessons for Europe’s future economic governance
With Estonia having just joined the beleaguered eurozone, and with Latvia and Lithuania determined to follow as fast as they can, Anatoli Annenkov and Erik Berglöf look at the lessons the Baltic states’ economic policymaking may have for the whole EU
As the eurozone’s various debt crisis unfold, and as European Council president Herman Van Rompuy’s task force searches for longer-term solutions to Europe’s economic governance challenges, the EU Baltic countries can offer important lessons and even some hope.
In the run-up to the eurozone crisis, Estonia, Latvia and Lithuania all showed how rapid integration without a supporting regulatory and supervisory framework and a counter-balancing fiscal policy could cause macro-economic imbalances and create new vulnerabilities. But since the crisis broke they have also demonstrated economic flexibility, coordinated crisis management and some decisive economic policymaking. On the final outcome, the jury is still out, but these features all helped mitigate the impact of a crisis and improve competitiveness without the need to adjust their longstanding fixed exchange rates with the euro.
No other countries in Europe saw such a dramatic build-up – and subsequent reversal – of external imbalances as have Estonia, Latvia and Lithuania in the last decade. When the global economic crisis hit the region in 2008, the current account deficits in all three countries had reached levels of around 20% of GDP. Rapid credit growth and booming domestic demand had set external debt on an unsustainable path. Yet once the nadir of the crisis had been reached, deficits contracted rapidly and by early 2009 all three had surpluses – primarily as a result of dramatic cuts in imports but also due to their surprisingly resilient exports.
Along with Ukraine, the three Baltics were the hardest hit countries anywhere in the world. Estonia, Latvia and Lithuania had in 2009 suffered declines in output of -14.1% -18.0% and -14.8%, respectively. By the middle of 2010 they were still only tentatively coming out of recession. Because of their fixed exchange rates they opted for “internal devaluations”, meaning domestic cost adjustments to improve competitiveness. All three are currently undergoing draconian fiscal adjustment, in Latvia’s case under a rescue programme provided by the IMF and the European Union. Fiscal retrenchment in 2009 amounted in Latvia to about 11% of GDP and about 8% of GDP in Estonia and 7% in Lithuania.
The full impact of the crisis and of these unprecedented budget measures has yet to be seen, but already some lessons can be drawn for Herman Van Rompuy’s economic governance agenda for the EU as a whole.
The first lesson concerns Van Rompuy’s aim of looking at how current accounts are financed. The Baltic experience warns that we must not fall into the trap of relying solely on simple ratios like that of the current account deficit to GDP. Capital flows are not inherently good or bad, and Europe as a whole has benefited enormously from flows of funds from capital-rich to capital-poor countries, just as it says in the textbooks. Until 2004, the current account deficits in the three Baltic countries were largely financed through foreign direct investments that in the main supported beneficial intra-industry integration. Unlike most other emerging markets, capital inflows in the European transition region had supported sustainable growth during the decade of global boom.
These capital flows can, as the Baltic economies show, at the same time be deeply destabilising, especially when their adverse effects are not counter-balanced by domestic policies. As liquidity in the global markets increased in the build-up to the crisis, foreign direct investment (FDI) constituted a diminishing part of the capital flowing into the region. In the Baltic states and in many other parts of eastern Europe, after the boom took off in 2004, capital flows increasingly went into the non-tradable sector, notably real estate and construction, instead of into building-up competitive export industries.
Before policy conclusions can usefully be drawn, capital flows must be carefully dissected in terms of their specific form and purpose to see whether they are exploiting cheaper production costs and specific talent pools that help build European competitiveness, or whether they are feeding unsustainable asset and construction booms. When making this analysis, surplus countries also need to be reviewed because surpluses can originate from structural rigidities and inefficient markets.
The second lesson for Van Rompuy’s team is about the need for a coherent framework for crisis management that as well as the private sector brings together home and host authorities of key financial institutions. At the outbreak of the crisis, Europe lacked a tested and credible framework for managing crisis in what had became a deeply integrated financial system. It was only through improvisation and independent action by international financial institutions that a coordinated crisis response finally emerged. Nevertheless, it was a policy response that saved the Baltics – and the rest of central and eastern Europe – from a traditional emerging market crisis with collapsing currencies and system-wide bank failures.
The Baltic crisis response was built around a massive EU-IMF programme that was also supported by those member states that were particularly affected, notably the Nordic governments that in terms of the Latvian economy amounted to over 30% of the country's GDP. The larger banking groups also received sizeable guarantees from the Swedish government, while the European Central Bank provided swap lines to reinforce the currency reserves of non-eurozone Sweden and Denmark. Like all the large banking groups’ active in central and eastern Europe, the Swedish banks committed to maintaining their exposures in the Baltic subsidiaries under the Vienna Initiative, the framework for coordination between home and host country authorities and the banking groups initiated by the European Bank for Reconstruction and Development (EBRD) and the IMF.
Without this coordination, things could easily have taken a sharp turn for the worse. At the height of the crisis, the Baltic governments faced a stark choice between departure from their currency boards, which would have delayed considerably euro membership, or internal adjustments supported by the international community. An immediate exodus from the currency boards in the midst of the crisis could possibly have speeded up an export-led recovery, but it would also have seriously deepened the crisis in the financial sector and sent shock waves far beyond the Baltic region. If Latvia, for example, had left its peg, that would immediately have forced Estonia and Lithuania to consider doing likewise. A wave of competitive devaluations could then have followed across eastern Europe, probably ending up in a more traditional emerging market crisis. At a time of global financial sector instability, this would have led to even deeper falls in output and more severe fiscal problems throughout Europe as a whole. The stability of the Nordic, and indeed the European, banking system was maintained, but now the citizens of the Baltic countries are paying the price through sharp cuts in wages and public services. Their sacrifice has yet to be fully appreciated.
The Van Rompuy task force should note that the international financial institutions, particularly the IMF but also private sector-oriented development banks like the EBRD, have important roles to play in an overall crisis management framework. The Vienna Initiative – in Brussels-speak, the European Bank Coordination Initiative – could offer a more permanent mechanism for bringing in these institutions and ensuring effective coordination between home and host countries, and between the authorities and the private sector. After all, the crisis in the Baltics as well as the rest of central and eastern Europe was primarily one of private sector debt.
The third lesson concerns Van Rompuy’s ambition to include competitiveness issues in macroeconomic surveillance. The Baltic lesson is that to become competitive, countries must be able both to cut domestic cost levels and to address long-term productivity. While the eurozone countries have become more similar in terms of real sector business cycle, they have not converged in terms of wage formation and inflation.
Just like countries on the EU’s southern periphery, the Baltic states had in recent years allowed wages to increase much faster than productivity, thereby losing competitiveness. With limited domestic labour supplies and inflexible labour inflows, wage pressures pushed up inflation, which in turn resulted in negative real interest rates. The result was that these economies’ rapid growth was based on excessive debt creation and capital inflows into housing, construction and financial intermediation.
Like the eurozone countries, the Baltic Three have to rely on politically difficult “internal devaluations” to improve competitiveness, rather than on adjustments of their exchange rates. The positive news for the Van Rompuy task force is that the Baltic experience shows that these internal devaluations can work. With a high degree of labour market flexibility, nominal wages have declined significantly (by some 9-16% of average gross wages), and have significantly improved their price competitiveness. This is even more relevant given that the Baltic countries’ exports are more sensitive to changes in the real effective exchange rate than most other competitor countries. External imbalances have rapidly been corrected, with export market shares developing favourably. As stressed by academics and policymakers, this kind of flexibility is crucial for a currency area that lacks large fiscal transfer mechanisms.
But the example of the Baltic states also illustrates the fact that competitiveness is about more than just fiscal discipline and cutting wages. It is also about building a strong institutional framework capable of coping with change, even in adverse economic conditions. For many years the Baltic economies were hailed as star performers – they were among the first transition countries to liberalise markets, they introduced business environments in line with best practice and kept their public sectors relatively small. They failed to contain the expansionary effects of low or even negative real interest rates in recent years, but the policy foundation remains highly credible. What is needed now is more focus on the structure of exports, raising their value-added and bringing down remaining barriers to trade.
In a number of important respects, the Baltic states are thus paving the way towards a less vulnerable and more competitive Europe. But they will still have to contend with many challenges ahead, and the sacrifices their people are already making are still not enough to guarantee success. Even if their “internal devaluations” so far seem to have worked, we cannot conclude that sticking to fixed currency regimes during the period leading up to the crisis was necessarily better. International experience suggests that a floating exchange rate and a credible central bank can reduce boom and bust periods. For the Baltic countries, the tradeoff was clear; floating exchange rates would have helped counter-balancing inflation in 2005-07, but would have speeded up lending in foreign currency and increased external imbalances, and so potentially exacerbating their vulnerability when the crisis hit.
The hope for the countries along Europe’s southern periphery, and for Ireland, is that economic restructuring without devaluation can work. But unlike the Baltic states these countries cannot count on the enforcement power of the accession process. In many ways, the disciplining effect of the euro system is greater for candidates than for members. The eurozone must find substitutes for the enforcement power of this “outside anchor” to help countries inside the monetary union commit to sustainable policies. Without a stronger “internal anchor” the union looks doomed to suffer from persistent imbalances and perpetual economic instability.