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MAIN DEvELOPMENTS IN THE BALTICS DURING 2000-2012

Expansion (2000-2007)

The three Baltic economies experienced a strong expansion in the period from 2000 to 2007, when annual real growth averaged about 8 per cent (see Table 12.1).2 To a large extent the robust growth was based on a rapid increase in the productive capacity of these economies. According to estimates by the European Commission, the potential output during that period expanded by 6 per cent annually. However, cyclical factors also played a significant role, especially during the latter part of the expansion. Although the Baltic countries entered the expansion with small negative output gaps, positive output gaps in all three countries exceeded an astonishing 10 per cent of their potential output near the peak of the cycle.

The primary driving force of the positive and reinforcing cyclical developments was the exceptionally high bank-intermediated capital inflow which led to a rapid credit expansion. From the supply side, these flows were generally supported by optimism regarding the growth prospects in the region and global factors such as low risk aversion and ample liquidity. Specifically to the Baltic countries, the very high relative level of these flows could be explained by the small size of these economies and by their proximity to the Nordic countries, where banks (especially the Swedish ones) had been among the first in Europe to start an active expansion of their retail banking activities abroad (Riksbank, 2007). In the process, the Nordic banks3 opted for aggressive business strategies to gain market share and set nominal interest rates and other loan conditions at levels quite similar to their home markets.

The impact of these capital flows was magnified by several well-known channels. Firstly, the economic expansion and credit boom were amplified by the workings of the real interest rate channel. The credibility of the Baltic exchange rate regimes4 and very optimistic credit risk assessments led to low nominal interest rates. This in turn accelerated output growth and inflation. As nominal interest rate dynamics were not affected by higher inflation, a strong positive feedback loop between decreasing real interest rates and accelerating growth and inflation took hold.

Table 12.1 Selected macroeconomic variables of the Baltic countries in 2000-2012

2000-03

2004-07

2008

2009

2010

2011

2012

Real GDP growth (year on year, %)

7.4

8.8

-1.3

-15.6

1.1

6.3

3.2

Contribution of private consumption (percentage points)

4.6

7.4

-1.9

-12.6

-0.5

2.6

Contribution of government consumption (percentage points)

0.4

0.6

0.4

-0.7

-0.4

0.2

Contribution of investments (percentage points)

3.4

4.7

-5.8

-15.8

1.7

5.3

Contribution of net exports (percentage points)

-1

-4

5.9

13.5

0.3

-1.7

Share of manufacturing (% of GDP, constant prices)

16.1

16.3

15.5

14.3

16.3

17.5

Share of construction (% of GDP, constant prices)

6.2

8.2

9.5

7

5.9

6.5

Output gap (% of potential GDP)

-1

7.3

6.8

-10.1

-8.2

-2.2

-1

Inflation (year on year, %)

2.2

5.1

12.3

2.4

1

4.5

3.3

Unemployment rate (%)

13

7.5

6.3

14.8

17.9

14.7

13

Fiscal balance (% of GDP)

-1.4

-0.3

-4.4

-6.4

-4.7

-2.6

-2.2

Cyclically adjusted fiscal balance (% of GDP)

-1.1

-2

-5.5

-4.1

-2.6

-1.9

-1.7

General government gross debt (% of GDP)

13.8

11.2

12.4

23.1

28.2

27.4

28.5

Current account balance (% of GDP)

-6.9

-13.6

-11.9

5.6

2.5

-0.2

-0.7

Domestic investment (% of GDP)

25.3

32.7

29.5

16.6

18.6

23

23.8

National saving (% of GDP)

18.5

19.2

17.7

22.2

21.1

22.8

23.1

Share of world exports (5-year change)

26.7

44.8

34.6

21.3

8.9

20

CPI-based REER (year on year, %)

1.3

1.4

7.6

4.6

-5.6

0.8

Real unit labour costs (year on year, %)

-2

1.7

5.4

-0.6

-8.3

-4.1

-0.2

Nominal ULC-based REER (year on year, %)

0.7

8

10.1

-3.8

-8.8

0

Private sector debt (% of GDP)

56.1

100.1

126.1

136.8

123.1

109.4

Private sector credit flow (% of GDP)

11.2

26.9

12.2

-5

-6.2

1.2

Gross external debt (% of GDP)

56.3

85.7

106

122.8

122.4

108

Net international investment position (% of GDP)

-42

-63

-69.1

-74

-69.5

-61.2

Real long-term interest rates (%)

4.8

-0.8

-4.3

9

6.6

1

Residential property prices (year on year, %)

20.6

34.8

-3.8

-36.9

-5.6

12.9

Note: CPI = index of consumer prices; REER = real exchange rate; ULC = unit labour costs.

Source: IMF (WEO database, October 2012), Eurostat, European Commission (AMECO database), Eesti Pank calculations.

Secondly, collateral and wealth effects played an important role. Rapidly increasing lending volumes increased the value of collateral by raising asset prices and increasing liquidity. This reduced reported loan losses and lowered the perceived credit risk of the borrowers, which in turn enabled the banks to continue extending credit. The positive financial loop between increasing collateral prices, loan volumes and economic activity was further magnified by the wealth effects from soaring asset prices.5

Thirdly, self-fulfilling expectations mattered. The relatively long period of high growth led to a gradual but quite significant rise in the estimates of the growth of potential output and long-run growth projections. Similarly the observed growth rates in several key economic and financial variables such as wages and property prices were often extrapolated to the future. All of this had a clear impact on investment and consumption decisions and thereby on economic activity. As a result, a strong reinforcing interplay between expectations and growth was formed.

In addition, the fiscal stance was slightly accommodative. Although the headline fiscal balances were quite close to zero in Latvia and Lithuania and in surplus in Estonia, the cyclically adjusted budget balances were slightly negative. The change in the fiscal stance was the largest between 2004 and 2007, when the cyclically adjusted budget balance deteriorated by two percentage points of GDP. In hindsight we can see that the fiscal policy did indeed act in a procyclical fashion.6 However, it is hard to argue that a fiscal impulse of this size could have been a primary driver of the boom.

All of the above-mentioned factors - high capital flows via the financial sector, the feedback loops between the financial sector and the real economy, self-fulfilling expectations and an accommodative fiscal stance - contributed to a picture typical of foreign-financed credit booms. Real growth was increasingly based on the expansion of domestic demand; the current account deficit reached very high levels and high credit growth led to a rapid rise in private sector indebtedness. By the end of the expansion inflation accelerated and price and cost competitiveness indicators started to worsen. In addition to the build-up of financial and external imbalances, structural imbalances appeared. As a result of the credit boom, there was a rapid increase in the share of employment and value-added created in the construction and real estate sector.

In contrast, the developments in the competitiveness and export performance of the Baltic economies were not so clear-cut. The rapid expansion of the economy did lead to a clear increase in unit labour costs during the second half of the boom and to an increase in the consumer price-based real exchange rate by the end of the expansion. However, the worsening of the price and cost competitiveness indicators did not have a visible impact on exports, which continued to expand strongly until the end of 2008, when foreign trade collapsed globally. This is also evident in the dynamics of the share in world exports, which continued to grow throughout the expansionary phase.

 
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