Fitch has long highlighted substantial current account deficits (CADs) and external financing requirements, rapid bank credit growth and rising external debt ratios as rating weaknesses in the Baltic States. In August 2007, Fitch downgraded Latvia's ratings by one notch, and during December-January it revised the Outlooks to Negative from Stable for all three countries, citing elevated financing risks from the global credit shock.
The further deterioration in global and, especially European, financial conditions and the likelihood of recession in the euro area have heightened the risks for economies with large external financing needs and reliance on bank financing. All three Baltic economies are in the top ten of those with the largest gap between outstanding bank credit and bank deposits relative to both GDP and total bank credit.
Reassuringly, a macroeconomic adjustment is under way in the Baltic States. Credit growth has been easing for several quarters and Fitch forecasts Estonia's CAD to narrow to 10.5% of GDP this year from 17% in 2007, Latvia's to 15% from 23%, but Lithuania's to increase to 14.5% from 13% (though the trade deficit is narrowing). Nonetheless, financing requirements remain substantial. Fitch projects 2009 gross external financing requirements (CADs and medium- and long-term amortisation) plus short-term external debt at around 400% of end-2008 foreign exchange reserves in Latvia, 350% in Estonia and 250% in Lithuania, the highest ratios in emerging Europe.
Furthermore, this rebalancing is taking a toll on the real economy. Real GDP contracted in H108 (on a quarter-on-quarter seasonally adjusted basis) in Estonia and Latvia, meaning they are in recession. This represents a "hard landing" from year-on-year GDP growth of 8.1% and 11.6%, respectively, in H107. In Lithuania, the slowdown, like the preceding economic boom and imbalances, is less marked, but GDP growth still slowed to an annualised 2.4% in H108, from 8.8% in 2007. Furthermore, 19% of its merchandise exports go to its Baltic neighbours and linkages through common bank ownership are significant. In addition, all three countries have suffered an inflationary shock: the latest 12-month harmonised consumer price inflation rate for August is 15.6% in Latvia, 12.2% in Lithuania (the two highest in the EU) and 11.1% in Estonia.
A hard landing and high inflation are making macroeconomic policymaking more challenging. The slowdown in bank credit and GDP growth, and falls in property prices are already having an adverse affect on budget balances and bank asset quality, albeit from strong starting points. Strong public finances are a key support to sovereign creditworthiness and provide headroom for governments to help cushion the slowdown. At end-2007, government debt was just 2.7% of GDP in Estonia, 9.7% in Latvia and 17.3% in Lithuania. Relatively strong institutions and flexible economies should also help the adjustment. Nonetheless, with limited policy tools available to manage the adjustment given fixed exchange rate regimes - which Fitch expects to remain in place - and the dominance of large foreign-owned banks, the risk of a prolonged and deep recession cannot be wholly discounted, increasing the potential for adverse economic and fiscal shocks.
