Analytics, Baltic, Economics, Rating

The Baltic economies have fully recovered from the crisis with the output gaps having turned positive in all three countries, and the unemployment rates at their post-crisis lows. Estonia, Latvia and Lithuania share many economic and fiscal strengths, reflected in Scope’s credit ratings of A+/Stable, A-/Stable and A-/Stable respectively. Scope public-finance analyst Levon Kameryan looks in more detail at the sovereign outlooks for the three Baltic countries.

What sets the Baltics apart from other countries in Central and Eastern Europe?

The three countries have sound public finances in common, marked by low and declining debt burdens, a government commitment to fiscal consolidation, and favourable debt structures. Estonia’s public debt stands out, estimated at just 8.8% of GDP in 2018, while Latvia’s and Lithuania’s will be 35% and 37%, all among the lowest in the EU. Much of the public debt is denominated in euros helping minimise external risks, with respectable average maturities of above 8 years for Latvia and 7 years for Lithuania as of Q3 2018, among the longest in the CEE region. Estonia’s entire debt issuance is in euros, while it also benefits from the best reputation for governance and ease of doing business in the region. Euro area peers Slovakia (A+/Stable) and Slovenia (A-/Stable) have a considerably higher public debt at an estimated 49% and 70% of GDP respectively. Bulgaria (BBB/Positive) and Romania (BBB-/Negative), with the lowest public debt among the non-euro area peers, have high foreign-currency exposure.

Have the three countries’ small economies benefited from EU and euro area membership?

Estonia, Lithuania and Latvia are eligible to receive European Structural and Investment Funds (ESI Funds) equivalent to around 20% of GDP each for the period 2014-20. The funds have contributed to the steady catch-up process, with the per capita income in the three Baltic states relative to the EU average up by around 10 percentage points since 2011.

Are there new challenges emerging?

In the medium-term, the three countries face two structural challenges. First, their economies have been growing above potential, as reflected in growing labour-market capacity constraints. Latvia’s work force has shrunk by 1% a year since 2012 amid an ageing population and net emigration. Wages have started to rise faster than productivity, as is also the case in Lithuania and Estonia. Secondly, as ESI funds diminish, the pressure increases on three small and open economies to improve potential growth, which stood at an average of 2.8% for Estonia, 2.5% for Latvia and 2.1% for Lithuania in the period 2015-17, through greater emphasis on research and development, and innovation.

How sensitive to external factors are the three economies?

As small, open economies, they are reliant on external demand and vulnerable to external shocks, reflected in large, albeit improving, negative net international investment positions of -51%, -35% and -29% of GDP for Latvia, Lithuania and Estonia respectively, as of Q2 2018.

The three countries retain close economic ties to Russia – accounting for 15% of Lithuania’s, 9% of Latvia’s, and 7% of Estonia’s exports – on which the EU has imposed sanctions since the Kremlin’s 2014 annexation of Crimea. However, more broadly, the Baltic states’ exposures to global value chains are somewhat lower, at around 50% of total exports on average, compared with around 65% for Slovakia, Hungary (BBB/Positive) and Czech Republic (AA/Stable). More importantly, the shift toward higher value-added output will be key to maintaining sustained growth in the medium-to-long term.

While the underlying fundamentals of the financial sector in each country are good, with well capitalised banking sectors, the interconnectedness of the Baltic and Nordic banking systems presents risks of its own. Nordic banks dominate the Baltic sector, so problems they encounter at home – in the instance, for example, of a sharp correction in Swedish housing prices – could spill over.