Size isn't everything
Three of the smallest members of the EU can boast of the fastest growth in the bloc. In the first nine months of 2005, Lithuania’s gross domestic product grew by 6.9% (year on year) Estonia’s by 9.1% and Latvia’s by 10.1%. The EU as a whole managed a miserable 1.6%.
Although these countries have been criticised within the EU for overheating their economies, they have some catching up to do. According to the EU’s own data for 2004 per capita GDP, Estonia’s purchasing power was 50% of the EU-25 average, Lithuania’s 48% and Latvia’s 43%, the bloc’s lowest.
After the Baltics became independent in 1991, their economies suffered some of the biggest collapses in the former Soviet Union. This made their subsequent recovery that much more impressive. Trade has diversified, with the EU now the main partner, services account for a growing proportion of the economy, and manufacturing has been rebuilt.
Agriculture’s contribution has declined dramatically, although in Latvia and Lithuania it still accounts for around 15% of the workforce.
The Baltics have different manufacturing strengths. For instance, timber, food and vehicle components go well in Latvia, light engineering and oil products are strong in Lithuania, and Estonia (dubbed e-Estonia) focuses on the knowledge economy - it now has online tax filing and voting.
After manufacturing, the Baltics’ second biggest sector in terms of GDP is real estate.
Booming sectors include tourism. Visitor numbers to Estonia and Latvia rocketed after each hosted the Eurovision Song Contest and both are also popular stag night (pre-wedding party) destinations. Latvia, which managed to attract both easyJet and Ryanair, is leading the pack in terms of overseas numbers, although all three saw a big rise after EU accession in 2004. Increased living standards and disposable income have transformed the retail sector, albeit at the expense of small shops, which have been virtually squeezed out of the major towns and cities by large store developments.
There is still pent-up demand for residential housing after decades of cramped living in the Soviet era. The most important driver in the residential sector has been the development of the mortgage market. The growth of housing loans has been explosive, soaring by more than 90% in 2005 in the case of Latvia. In Estonia, where housing loans went up by 75% to total e2.6bn at the end of last year, tax relief and cheap euro-denominated credits mean that Estonians can currently borrow at below the rate
Meanwhile, the banking sector is fighting for mortgage market share, with increasingly longer terms and looser earnings qualifications. None of these countries has yet experienced a property crash, which, for Estonia’s central bank at least, is a worry in itself. It recently raised the risk weighting on housing loans in order to try to restore some prudence to the market.
The financial sector nevertheless remains stable. All three central banks have a high level of credibility, and large foreign groups, mainly Scandinavian, own most of the banking sector in both Estonia and Lithuania. Latvia is the exception in that one of its largest banks, Parex, is locally owned.
Latvia has a relatively large number of banks, more than 20, although only a small number are allowed to take deposits. The country has for years been a destination for regional “flight capital”, with many Russians still making their deposits in Riga. The less savoury side of this “offshore” banking has brought rebukes from the US Treasury for two Latvian banks. However, Latvia has brought its money-laundering laws into line with EU standards.
Wages are still low by west European standards. In the first months of 2005 gross monthly earnings averaged e500 in Estonia, e373 in Lithuania and e353 in Latvia. This has made the region, especially Estonia and Lithuania, attractive locations for outsourcing and sub-contracting. It was one of the big draws for inward foreign investment, alongside a well-educated population, the promise of EU membership and, in the earlier post-independence years, a big pipeline of privatisations. But salaries are rising fast and in the case of the clothing industry, once a big exporter for the region, sub-contractors and local firms are moving to Ukraine, Moldova
and other lower-wage economies farther east.
Falling unemployment is putting further upward pressure on wages and costs, as is the declining population. Some sectors of the economy, construction in particular, are facing shortages of skilled labour that contribute to the common overrun in real estate project completion and rising property prices. Skilled workers are being lured in from Russia and Ukraine.
The small populations of the Baltics would not be a problem were it not for the fact that they have been declining for some time. Since independence in 1991, Lithuania’s population has fallen by 10% to 3.4m, Latvia’s by 16% to 2.3m and Estonia’s by 17% to 1.3m. The proportion of elderly people in the population is also growing, and all three countries have reformed their pensions system.
Estonia has tried to address the decrease by increasing child benefits and offering longer paid maternity and paternity leave. EU accession brought an additional problem of free labour movement with the UK, Ireland and Sweden opening their borders up immediately, while Finland is set to do so later this year. Although relatively few Estonians have taken up the opportunity, a sizeable number of Latvians and even more Lithuanians have. Around 37,000 Lithuanians were registered in the UK between May 2004 and 2005, the second largest ethnic group of “new” EU migrants after Poles.
Unemployment rates, at 8.3% in Latvia, 6.8% in Lithuania and 6.7% in Estonia, were below the EU average of 8.5% at the end of last year. In addition these countries also enjoyed some of the highest relative falls in unemployment.
They also have their unemployment blackspots in heavily industrialised regions such as Estonia’s northeast. Although transport links are improving, there is still little understanding of labour mobility across the country. The capital cities attract the highest investment and have the best job prospects. In Latvia around a third of the population lives in the capital, Riga.
Estonia has the most highly urbanised population, at 70%, with around 30% living in the capital, Tallinn. In Lithuania, the population is more evenly distributed, with only 15% living in the capital, Vilnius. Kaunas and the port city of Klaipeda are also major population centres.
The Baltics’ small population size has a political context. During the Soviet occupation in the 1940s around half of the local population was deported, after which large numbers of Russians moved into the region. At the start of the 1990s large Russian minorities accounted for around 40% of Estonia’s population and close to 50% of Latvia’s. Following independence both countries enacted controversial laws restricting citizenship (and national election voting rights) to those born in the country before 1940 and their descendents. Lithuania, with its smaller ethnic minority, granted universal suffrage.
The citizenship laws, including language requirements for those minorities wanting citizenship, have been softened under international pressure, but with around 20% of Latvian residents still classed as non-citizens, these policies continue to colour relations with Russia. The Russian parliament has still not ratified border treaties with Estonia and Latvia. In the run-up to EU accession Russia played hard-ball by trying (unsuccessfully) to have the new east European members excluded from its preferential trade treaty with existing members.
However, it’s a measure of the dramatic change in Russia’s own political relations with the west that the Baltics’ membership of Nato, considered unthinkable in the early 1990s, took place in March 2004 almost unnoticed.
All three Baltic countries nevertheless have an uncomfortable economic dependence on Russia. It supplies all their gas and most of their oil. The Mazeikiu Nafta oil complex in Lithuania, which includes the only refinery in the Baltics, runs largely on Russian crude. In 1999 a highly controversial privatisation aimed at keeping the complex out of Russian hands backfired four years later when a Russian company took majority control. That company was Yukos, and the government is now engaged in complicated dealings to pass the shareholding on to another investor.
Oil transit is important business for the Baltic countries. Their generally ice-free ports made them strategic assets for the Soviet Union, and Russia still uses them to export its oil westwards, but that business is declining noticeably as Russia develops its own ports. Russian interests are nevertheless keen to buy into the Baltics’ own infrastructure, by whatever means. One of the most blatant examples of Russian muscle-flexing has been the oil boycott, since 2003, of Ventspils Nafta, Latvia’s oil pipeline and terminal, after the Latvian authorities refused to consider Transneft, the Russian oil pipeline monopoly company, as a potential investor in Ventspils.
Although the Baltic states still get their gas at much lower prices than western Europe, this comfortable situation is not going to last. Neither is their own energy generating capacity. Estonia fuels its largest power plants with its oil shale, but under its EU accession agreement it must phase the fuel out in favour of less polluting sources.
Lithuania yielded to EU pressure to shut down its Ignalina nuclear plant, the world’s largest Chernobyl-style facility. One of the two reactors was shut at the end of 2004, the second closure is set for 2009.
This has not been a popular decision in Lithuania - the country got around 80% of its electricity from the plant, while a big surplus went for export - and postponing the final closure returns periodically to the political agenda. If not Ignalina, then why not a new nuclear plant? Plans for a new plant in Lithuania co-funded by Estonia and Latvia are still in their infancy, but are being fleshed out, with neighbouring countries like Poland expressing an increasing interest.
Politically, all three countries are parliamentary democracies with a single chamber. The president, directly elected in Lithuania and by their respective parliaments in Estonia and Latvia, is nominally head of state but with primarily ceremonial roles.
Personalities and business interests play a greater role than in western democracies and account for the plethora of parties that would be otherwise impossible to distinguish on policies.
The high number of parties - Latvia has 20-plus - has invariably meant coalition governments and their associated problems. Lithuania’s system is the most stable and the only one with a recognisable left-right political spectrum: the Social Democratic Party, the successor to the Communist Party of Lithuania, is currently governing in coalition. Latvia, meanwhile, is on its third government since the 2002 elections.
Although government collapses are a part of the Baltic landscape, there is a general consensus on economic and foreign policies that makes up for the instability. The long process leading up to EU accession focused political minds on bringing political and legal systems in line with European norms. Successive European Commission reports acknowledged that one of the problems of the Baltic legal systems was a lack of administrative capacity, causing long delays in hearings.
The next goal is adoption of the euro. Estonia and Lithuania joined ERM II in June 2004, aiming to adopt the euro at the earliest possible opportunity - January 2007 - while Latvia hopes to join a year later.
Since all the currencies are pegged to the euro under a currency board system, they are stable. There have been relatively few speculative attacks since the three countries abandoned the rouble, all of them unsuccessful. One problem associated with currency board is that the central bank has few if any monetary policy tools to control inflation, and inflation could derail the euro ambitions of all three.
Apart from a brief period of hyperinflation following independence, inflation in all three countries has come down to low single-digit rates. After EU accession there was a predictable rise in prices caused by VAT harmonisation. However, rising oil prices have made matters worse, especially so in the Baltics than in the “old” EU because energy efficiency is still nowhere close to western Europe. Latvia’s inflation is currently the highest in the EU (7.1%), Estonia’s the third highest (3.6%) and Lithuania’s the sixth 3%). These are contrasted with an EU25 average of 2.1%.
None of the Baltic states can realistically meet the Maastricht inflation criterion, and the fact that back in 1999 Italy and Belgium had the rules bent to allow them into the eurozone is not cutting any ice this time around. If anything, there is growing antagonism among the current members towards the Baltics joining.
In 2004 the European Central Bank warned that the poorer applicants risked jeopardising their growth potential by focusing on euro targets; more recently the Bundesbank stated that they were just too poor. But any setback would only be temporary. More worrying would be renewed pressure from countries such as France and Germany for the new EU members to raise their low corporate tax rates, although with Ireland setting the precedent - and providing a growth role model for all the new EU members - this would prove a harmonisation too far.