A Bursting Baltic Bubble?

Are the Baltic states facing an impending economic crisis? So seems to be the case, due to the current overheating of both Estonian and Latvian economies. Earlier this week, Standard & Poor's as well as Deutsche Bank warned that Latvia's economic imbalances might cause a currency devaluation. Estonia risks a similar fate in the runup to its 4 March parliamentary elections. Only Lithuania seems to be getting off scot free.

In January, Standard & Poor declared Latvia Europe's "most dynamic economy in 2007" with a GDP growth of 8.9%, and with neighbouring Estonia coming in second, with a 7.5% growth. Estonia and Latvia - along with Slovakia - are the fastest growing economies in Europe.

Growth, however, has a price. Both economies are facing an inflationary spiral with most economic indicators going wild. In the battle over customers, Latvian banks have lended money to consumers at an interest lower than the inflation rate, and Estonian banks have followed suit.

However, Latvia's problems are the most acute. Since January, economic growth has risen to 11%, by far exceeding the 6-7% that are long-term economically sustainable. High domestic demand and corporate investment rates add to the problems. The increase in imports - clearly over what the country exports - has also created a worryingly negative balance of trade.

As for the labour market, supply cannot meet demand as many Latvians work abroad. The annual wage-rises of an average 10% have so far been compensated by a corresponding growth in productivity, but this year the tendency is towards an impassable 20% rise.

What may really topple the economy, however, is the negative real interest rate combined with a high rate of public lending - largely in euro-loans. According to some sources, this has caused prices of real estate to double in recent years.

All in all, if Latvia were now to devalue its currency - the Lat - banks would be forced to compensate themselves by a drastic increase in interest rates. With loans largely in foreign currency, consumers would face acute solvency problems, potentially with a consequent crisis for the banking system. As it appears, recession seems to stand at the door.

So, what has the Latvian government done to curve inflation and battle economic overheating? Precious little, one must admit. Already last spring, Standard & Poor predicted several years' delay for Latvia's inclusion into the eurozone, postponing it for 2009-2010 at the earliest. Prognosis was based on sustained price growth, driven by demand and rising inflationary expectations. This, in itself, should have been a clear stop-sign for the Latvian government.

All the same, the Latvian economy is basically in good shape. The country's foreign debt is low and the state economy is under control. And, obviously, economy is booming. So, why waste a winning concept, seems to have been the reasoning of the government. Some measures have been made, but they have either failed or been dubious as for their effects.

Also, it is quite obvious that the government had had more reasons to be content. In October, the government coalition, led by conservative People's Party (Tautas Partija) leader Aigars Kalvītis, was the first to be re-elected since the country regained independence in 1991. No wonder the government had a laid back attitude to developments, wanting to enjoy its honeymoon with the voters as long as possible.

However, now the government has come to a rude awakening, as the situation has quickly gotten out of hand. The question is if it will dare to challenge the banking and financial sector, which - as in Estonia - belongs to its key support groups. It is questionable if the Kalvītis cabinet can rise to the challenge. In the meantime, the fear that the Baltic bubble bursts will linger on.

Russia: Dollar vs Rouble

Last week, the Russian State Duma proposed a law prohibiting the use of prices in foreign currency. For all practical reasons, this would mean that price-setting in dollar and euro would be banned in Russia. The law proposal, which stands good chances of being passed, has been much ridiculed by domestic and international media alike. However, is there really reason for such ridicule if one would only closer consider the general idea?

Russians like to set their prices in dollar for the simple reason that any bigger business transaction in Russia is made in dollar. With inflation rates of up to 2,500% annually in the early 1990's, Russians have grown accustomed not to trust the country's own currency, viz. the rouble. Therefore, most Russians also keep their savings in US dollar. Despite a mere 11% inflation rate last year, people remember the latest great financial crisis in 1998, when the rouble dropped some 86% in the course of a year. Today's relative macroeconomic balance in the Russian economy, not least due to rising oil incomes, is therefore not reflected by greater trust in the rouble. Only this year, the rouble exchange rate has increased by 7% against the dollar. However, this does not seem to change how Russians value the rouble.

Nevertheless, sound scepticism is currently motivated to the dollar as store of value. Earlier this Spring, Russian Finance Minister, Aleksei Kudrin, questioned the US dollar as international reserve currency. In view of how volatile the dollar course has been in recent years, Kudrin's question has some rationale. People and national banks alike have, to an increasing extent, turned to the euro to hedge currency risks. Of course, this challenges the advantage of seigniorage for the US economy, allowing the country its current budget deficit due to the Iraq war. However, US deficit has now reached such levels that trust in the dollar is inevitably dropping. That oil producers are tending to turn to the euro for setting oil prices instead of the dollar, is a worrying tendency for the US. In view of increasingly diverging interests between Moscow and Washington, Russia's increasing scepticism towards the dollar comes at a time when the US economy is vulnerable to critique. Whether Russian initiatives to rid itself of dollar dependency also have a political motive sparked by deteriorating US-Russian relations is too early to say.

For now, the new legislation is interesting enough. So, will such a law actually work? No, of course not. Banning public use of dollar or euro denominations will have absurd consequences. Looking only at president Putin's recent annual address to the State Duma, it would have rendered him a considerable fine, judging from the number of times he used the "d" word. The new law may also create considerable confusion at the upcoming G8 Summit in Petersburg, as the Duma has recommended the Russian delegation only to use rouble denominations when presenting financial data. Former Finance Minister Boris Fedorov argues that the law will make Russia an international laughing-stock. His successor, Aleksei Kudrin, predicts that state officials will become totally confused by amounts "followed by an infinite number of zeros."

Still, is it not quite natural that a state uses its own currency denominations as a measurement of transactions? What would e.g. an American say if all US prices were in euro, despite the fact that payment would be made in dollar? That a reserve currency - such as the dollar or euro - is used in inflatory or crisis economies is quite natural, because people want to be sure of the value of their money. However, the rouble has preserved its value relatively well for such a long time now, that one should perhaps start reconsidering its value also in psychological terms. This will take time, but one has to start somewhere. It is quite evident that an economy the size of Russia cannot in the long-run go on using foreign currency as its financial gauge. The price of this is too great, not least in terms of transaction-costs and non-deposited money with no interest. So, despite the fact that the specific Duma bill and the debate surrounding it may be laughable, Russia has to start somewhere to normalise its economy. In light of this, the Duma may not be all wrong.