REGIONAL REPORT: CENTRAL & EASTERN EUROPE
Although hit hard by the global financial crisis, Latvia, Lithuania and Estonia recovered quickly. The three countries are building ever-closer EU ties to separate themselves economically from Eastern neighbors.
Situated on the European Union’s northeastern periphery, the three Baltic States—Estonia, Latvia and Lithuania—have demonstrated a determination to forge ever-closer bonds with their Western neighbors over the past 20 years. Since they regained independence in 1991, their proximity to Russia and memories of the Soviet era have provided strong motivation for them to be model Europeans.
“EU and NATO accession in 2004 transformed the geopolitical world of the three Baltic states,” says Agnia Grigas, former adviser to the Lithuanian government and author of The Politics of Energy and Memory between the Baltic States and Russia (2013). “It provided greater security—not just militarily, but by adopting open markets and best legal practices, greater security for investors and a good environment for doing business.”
As a result, the Baltic economies achieved annual growth rates of 8% to 12% for a number of years as foreign investment poured in. There were already clear signs of overheating when the global financial crisis struck.
The impact of the crisis on these small, open economies was severe, but they bounced back faster than most. “The Baltics have integrated very well within the EU,” notes economist Wolf-Fabian Hungerland at Berenberg Bank, “which is now the destination for two-thirds of their exports.”
Adopting the euro was the next stage of integration. Estonia did so in 2011—despite the eurozone’s being in the midst of its banking crisis. Latvia joined earlier this year, and Lithuania’s entry is set for next January.
Alex Lehmann, the European Bank for Reconstruction and Development’s (EBRD) lead economist for the Central and Eastern Europe (CEE) region, notes that the Baltics’ pegging their currencies to the euro “obviously entailed a major macroeconomic adjustment, but opinion polls show that European integration has had phenomenal support in all three countries.”
Joining the eurozone, Lehmann says, was “the crowning achievement” for Latvia and Estonia—although in Latvia skeptics question the advantages. Nonetheless, he adds, while “the benefits of exchange rate stability were not widely appreciated, the political and security implications of being more closely integrated and the advantages of free movement of labor within the EU were very evident.”
Getting to the point where they could join the eurozone required strong discipline during the financial crisis. “While maintaining the currency link to the euro, they accepted internal devaluation and dealt with structural problems up front,” says Hungerland.
Latvia, whose economy shrank by almost 25% in 2009 and which had to accept savage cuts in social spending and wages, recovered rapidly. Lehmann notes that Latvia “has been held up as a role model for implementing structural and fiscal adjustment within a fixed-exchange-rate regime.”
“Yes, they are a good example of how internal devaluation can work in a politically supportive environment,” says Hungerland. “But that political support was also shaped by the population’s Soviet-era experience. In countries without this experience, popular acceptance of such measures is probably harder to achieve.”
Lehmann points to the “very significant investments from Scandinavian countries, which now dominate the banking and financial sectors,” adding that “these banks will benefit as of this year from the enhanced credibility of common supervision within the new EU banking union.”
ENERGY: ACHILLES’ HEEL
The strengths of the Baltics, says Hungerland, are sound fiscal policies, open markets, deregulated labor and political stability; their weaknesses—low household savings, high long-term unemployment and reliance on Russian gas.
Indeed, Grigas describes the Baltics’ energy sector as their collective Achilles’ heel, owing to their near-total dependence on Russian gas and oil supplies. “For 20 years there have been talks about diversifying energy supply, but there are still no LNG [liquid natural gas] terminals. That is partly due to competition between the three states, each of which wanted the project, and therefore the EU funding, within their territory.”
“These countries are too small for each to have an LNG terminal,” notes Hungerland.
Lithuania is now moving ahead with plans to build a floating LNG terminal in its Baltic seaport Klaipda, which is less costly and faster to implement than traditional, land-based terminals. The US shale gas revolution, coupled with Russia’s regional resurgence, as seen in Crimea, seems to have given the project more impetus. It is due to be completed by the end of this year.
Similar rivalries affect a planned undersea electricity interconnector from Sweden, which will split and provide power to both Latvia and Lithuania. Lehmann argues that a more closely linked electricity infrastructure is needed to cope with peaks in demand, as is an integrated price for the region.
There is also debate over where to put any new nuclear generation. “With nuclear power, it is important not to make themselves too reliant on Russian technology,” says Hungerland. Worries over energy security may also encourage exploitation of the region’s shale gas deposits.
RELATIONS WITH MOSCOW
Another concern is Moscow’s possible intentions over Russian-speaking minorities in the Baltics. The proportion of Russian speakers is highest in Latvia, followed by Estonia, with Lithuania having a rather small minority.
“The Baltics have reason to feel a degree of nervousness,” says John Lough, former NATO representative in Moscow and now associate fellow of London-based think tank Chatham House’s Russia and Eurasia Programme. “For a long time they have been saying that ‘Russia is a country we can’t trust, that is trying to undermine our sovereignty using a variety of means, including calls for protecting the rights of Russian-speaking communities.’”
Grigas notes that Estonia and Latvia’s citizenship laws—including tests in the national language—have created divisions in society. The Kremlin has assured Russian-speaking minorities of protection: Earlier this year a law was introduced in Moscow that facilitates granting citizenship to Russian-speakers in the “near-abroad.”
Lough points out that because the Baltics are NATO member states, their security, unlike Ukraine’s, is guaranteed by the West. But Russia could, if it chose to, undermine the Baltic economy. Hungerland notes that 17% of exports from the Baltics go to Russia and Ukraine—more than twice the CEE average.
Exports to Europe, however, are now far more important than they were even a decade ago. “Growth remains strong,” says Hungerland, who is forecasting an average GDP increase of 3.3% across the three Baltic States this year. The EBRD anticipates growth of 4.1% in Latvia, with Lithuania and Estonia growing by 3.3% and 2.8%, respectively.
In terms of competitiveness, Estonia’s high-tech industries are in the lead, according to Lehmann, though Latvia has adopted “a far-sighted vision of moving towards a knowledge-based economy built around innovative industries.” The EBRD is involved in helping SMEs diversify their products so as to reach broader markets, but Lehmann sees a need for more investment from private equity and venture capital funds.
The three Baltic states have made the transition to being fully integrated EU members more rapidly, and with greater commitment to the European project, than some other late joiners. Given that they started this journey as former Soviet satellites, their achievements are all the more remarkable.
Poland Outshines Peers In Post-Crisis Recovery
Poland is the poster-boy of the EU’s eastern expansion. The traction and resilience of its economy have been exemplary. Indeed, throughout Europe’s long recession, the Polish economy never once registered negative growth. “The benefits of EU membership—including the freedom of movement—have been enormous,” says economist Wolf-Fabian Hungerland at Berenberg Bank. “And people see it largely as much more beneficial than any Soviet-style economic policy.”
Although the Polish economy has flattened out recently, the European Bank for Reconstruction and Development (EBRD) forecasts growth accelerating from last year’s 1.3% to 2.7%. Hungerland likewise sees GDP rising to 2.8% this year. One potential weakness is that Russia accounts for 8.5% of Polish exports. But the largest concern, he says, is the current-account deficit, which is running at 2.3%. This exposes Poland to investor concerns and could result in capital outflows as monetary policy is tightened in the US and elsewhere.
Its one sticking point—as seen from Brussels—is its maintaining the zloty rather than adopting the euro. Even so, “Poland avoided many of the pitfalls [some countries have experienced] from rapid growth of the banking sector,” says Alex Lehmann, the EBRD’s lead economist for the Central and Eastern Europe (CEE) region. “The [Polish banking] regulator kept a lid on excess consumer and foreign currency lending, so when the financial crisis hit, Polish banks did not have to retrench so far as those in, say, Hungary.”
“Like many other CEE countries,” observes Hungerland, “Poland had large exposure to foreign currency loans, and during the financial crisis the cost of servicing this debt jumped.” The government’s response—forcing the conversion of loans into the local currency, tighter controls, and stress-testing the banking sector—was more successful than approaches applied in Hungary.
Poland came though the crisis better than its peers partly because domestic demand was more resilient but also because its economy is so closely linked to Germany’s.
“Poland is heavily exposed to the German business cycle,” says Hungerland, “and needs to diversify away from this dependency.”
Yet Poland is actually less dependent, according to Lehmann, than some other CEE countries like Slovakia, whose automotive and engineering sectors are closely linked to German industry. Noting its low R&D spending and slow product development, Lehmann says, “Poland has a highly diversified service sector—logistics, back office, call centers. Its real challenge is to be more innovative.”