Three points about the Baltics

SEB MERCHANT BANKING – COUNTRY RISK ANALYSIS June 21, 2008

Analyst: Rolf Danielsen. Tel : +46 8 763 83 92. E-mail : rolf.danielsen@seb.se

May 27-29, 2008, we visited Tallinn, Vilnius and Riga to gather information about
the three Baltic countries. Despite perfect weather, this trip was a rather chilling one.

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First: The turning point
New Car Registrations
Changing winds: All three countries, but (units per month)
10000
most so in Latvia and Estonia, are marked by 9000
changing winds. The salient feature of 8000
people’s feel good factor, namely their new 7000
6000
car purchases is a clear testament to changing 5000
sentiments in the two northern countries, with 4000
drops in January 2008 of some 24% in Latvia 3000
2000
and 3% in Estonia yoy while the
1000
southernmost, Lithuania, is still continuing the 2002 2003 2004 2005 2006 2007
binge with new registrations up 60%. As to Latvia, Total
asset prices, however, the chill is prevailing in Estonia, New cars
Lithuania, Total
all three countries. Stock markets are down Source: Reuters EcoWin

by 20-40% since the middle of 2007 – much more than the average emerging
market index, and property prices
are down by more than 10% all
over. Credit growth peaked in 2006
and has since then fallen to 15-20%
yoy. That, however is still not a
credit crunch although rapidly rising
inflation is eating into the real

Baltics Credit growth

80 70

70 60

60 50

values of new loans. Because, if anything is

50
Percent

40

still increasing, and even accelerating, it is –

Percent

40
unfortunately – prices. Gone are the days of 30

optimistic projections when officials assured 30 20

us of their steady path to price stability 20 10

needed to achieve EMU entrance criteria. 10 0

The overheating that became evident in 2007 00 01 02 03 04 05 06 07

has been further aggravated by a jump in Estonia, Domestic credits to the private sector, EEK [ar 12 months]
Latvia, Domestic credits to private enterprises, LVL [ + Latvia, Domestic credits to private person
Source: Reuters EcoWin

important your attention is drawn to the statement on the back cover of this report which affects your rights.
SEB Merchant Banking Country Risk Analysis June 21, 2008

Consumer Prices, Index

Annualized growth in percent

excise taxes on tobacco and alcohol as
20
required by their respective EU
15 memberships, and also by higher utility
prices following new price hikes on
10
imported oil and gas mainly from
5 Russia. Gas import prices have now
reached about $250/1000cm and will hit
0
2004 2005 2006 2007 2008 the consumers through the rest of the

Latvia, Total, 2000=100 [ar 12

year in particular as the heating season
Estonia, Total, 1997=100 [ar 12 kicks in after the summer. But $250
Lithuania, Total, CPPY=100 [a was the world-market price a year ago.
Source: Reuters EcoWin

Today Russia’s customers in Western Europe are paying $350, corresponding

to some $300 for Baltic customers taking lower transportation costs into
account. As could be expected, this has cooled consumer sentiment further
with retail sales coming to a virtual standstill in Estonia, indicating a
significant drop in constant prices – part of which is explained by the drop in
new car sales. Reported GDP numbers for Q1 in the case of Estonia shows a
sharp turn-around with to zero growth year-on-year (yoy). In Latvia and
Lithuania the deceleration has so far been smoother with growth moderating
to 3,6% and 6,9% respectively. (However, for Estonia the very weak number
may have been influenced by stock-building before the new sin-taxes of
January 1, complicating the assessment of the underlying situation without
the 2nd quarter 2008 estimate.)

But exports are still holding up reasonable well, correcting for Russia,
electronics, textiles …
M erchandise exports Merchandise exports 2007-2008
Annual growth in percent

35
Annual growth in percent

35
30
30
25
25
20
20
15
15
10
10
5
5
0
0
-5
-5
2002 2003 2004 2005 2006 2007
Q1 Q2 Q3 Q4 Q1
E ston ia, E xp orts, E E K [ar 12 m o n th s]
2007 2008
Estonia, Exports, EEK [ar 12 months]
Latvia, C urrent A cco u n t, G o o ds, C red it, LV L [ar
Latvia, Current Account, Goods, Credit, LVL [ar
Lith u ania , C urren t Ac co un t, G oo ds , C re d it, L TL
S ource: R euters E coWin Lithuania, Current Account, Goods, Credit, LTL
S ource: R euters EcoWin

In 2007, Latvian exports rose by 20%, accelerating from 14% the year before,
while Lithuanian exports moderated to 12% and Estonian to only 4%, the
latter down from 25% in 2006. Re-routing of Russian transit trade from
Estonia to Latvia may explain a part of these uneven performances, but also
specific developments, such as the temporary closing of the Mazheiku oil
refinery in Lithuania in 2007, played its role. The mid-year downscaling of
Nokia’s assembly plant for handsets also cut Estonia’s export growth as did
the continuing problems for the country’s textile industries.

So far in 2008, the numbers change the picture of relative performances

somewhat to the benefit of Lithuania on behalf of Latvia. It should be noted,
however, that about half of the Lithuanian export boom reflected oil products
since the upstart of Mazheiku following its reconstruction in 2007.

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SEB Merchant Banking Country Risk Analysis June 21, 2008

Imports are moderating. In 2007, imports to Latvia and Lithuania

decelerated from the stratospheric
growth levels of recent years but were M erchandise im ports 2007-2008

Annual growth in percent

40
still moving up at quite a rapid clip. In
the case of Estonia, by contrast, 30
imports slowed sharply in part
20
reflecting reduced Russian transit
trade. 10

0
Merchandise imports
Annual growth in percent

-10
Q1 Q2 Q3 Q4 Q1
30 2007 2008
Estonia, EEK [ar 12 m onths]
Latvia, LVL [ar 12 m onths]
20 Lithuania, LTL [ar 12 m onths]
S ource: R euters EcoW in

In the first quarter of 2008, Estonian

10 imports actually shrunk, while the
Latvian slowed to a meager 2% yoy
0 growth likely indicating a drop in
2002 2003 2004 2005 2006 2007
real terms. Lithuanian imports, by
Estonia, EEK [ar 12 months]
Latvia, LVL [ar 12 months]
contrast, rose 30% boosted by new
Lithuania, LTL [ar 12 months]
Source: Reuters EcoWin
feed-stock to the Mazheiku refinery.

Current account deficits peaked in 2007, but the external balances still
remain very weak. Continued export growth and moderating imports
provide little comfort, however, given
Current account balance the large trade deficits in the first place.
In 2007, these deficits reached 17%,
-5 25% and 14% relative to GDP in
percent/GDP

Estonia, Latvia and Lithuania

respectively. The positive balances on
-15 the income and services accounts of all
three countries have traditionally
mitigated the concerns of the trade
-25
2001 2002 2003 2004 2005 2006 2007
deficits but that effect seems to be
fading. Tourism, which dominates
Lithuania Estonia Latvia services revenues, has grown at a
Source: Reuters EcoWin

healthy pace since the beginning of the

Tourism
decade, but last year the growth rates Arrivals, overnight stays
dipped into negative territory. There is 60
Annual growth in percent

hope that new hotels now nearing their

completion in 2008 and 2009 will help 40
Latvia
attract more visitors, but it may also be the
case that prices have become too high. In 20
both countries prices for hospitality and
entertainment services 1 have risen even Estonia
0
faster than average consumer prices. In the
case of Estonia, they rose 10% in 2007. In
-20
the case of Latvia, they were up by more Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
2004 2005 2006 2007
than 20%. Latvia, ByCountry of Residence, Total Estonia, Overall, Nights spent, total Latvia, ByCountry of Residence, Total

Source: Reuters EcoWin

1
Subcategory ”Hotels and restaurants” in the Consumer Price Index.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

That means large current account deficits are here to stay although 2007 likely
marked their peaks at least for Estonia and Latvia. As such, the deficits could
remain at exceptionally high levels for coming years, perhaps making
investors increasingly wary of the three countries solvency. In the case of
Latvia and Estonia external debt has already passed the 100%/GDP milestone
by a wide margin, while in Lithuania it was still less than 80%/GDP in 2007.
However, in the case of Latvia, high debt ratios reflect in part non-residential
deposits representing some 46% of total bank deposits of which about half are
kept in highly liquid foreign assets by the deposit taking banks 2 . Correcting
for this reduces Latvia’s external debt to around 120% of GDP, which is still
an unusual high number by any comparison.

But the government’s financial position is still strong. The large external
debt ratios are mirror images of the high indebtedness of the private sectors --
households and companies, as a consequence of the very rapid credit growth
over the last four years mostly funded by foreign parent banks. The
governments, in contrast, have much stronger financial positions thanks to
overall balanced budget policies. Government debt levels are reported at
around 4% for Estonia, 8% for Latvia and 17% for Lithuania. Estonia’s net
asset position is even positive at more than 6% of GDP representing the
accumulation of recent years’ budget surpluses. This gives the three countries
and enviable position to cushion economic shocks by letting automatic
stabilizers function.

Second: The point of no return

Solvency The external debt ratios, even after correcting for specific factors
such as non-residential deposits matched by very liquid assets of the deposit
taking banks, stick out as unusually
high in the Baltic countries, in
particular in Estonia and Latvia. External debt/GDP
Debt at these high levels raises 150
concern about solvency. In theory, Estonia
p e rc e n t

the debt ratio will eventually 100 Latvia

stabilize as long as there is positive
GDP growth and the annual increase Lithuania
in the net debt (i.e. the current 50
account balance, ignoring valuation
changes) is a constant fraction of 0
GDP. But such a debt level may be
too high for comfort for most 1992 1997 2002 2007
investors. Compared to other large
emerging markets there are only two instances of higher debt/GDP levels in
the period since 1994: Argentina and Indonesia. In those cases, however the
high debt ratios were reached after deep economic crises during which their
currencies had been in almost free fall following many years of dollar

2
Latvija Bankas will in a forthcoming Financial Stability Report publish estimates that show
Latvian banks able to withstand a run on their deposit base from non-residents equal to 10%
of total non-residential deposits each day for five consecutive days without the banks
themselves running into liquidity problems.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

targeting and finally undershot their true values 3 . The future path of these
debt ratios in the Baltic countries over the next few years is likely to be
crucial. A back on the envelope calculation with a halving of the current
account deficits and GDP growth in nominal (euro-terms) terms to an average
of 10% and 5% respectively, shows debt to GDP not leveling off before
having reached 200%. For the debt ratio to stabilize at present levels, the
current account deficits would have to be reduced to only 5-7%, or more
generally to the same level as expected GDP growth. That is not likely to
happen unless more resources are redirected swiftly to export activities, which
depends on wages and other production costs.

The Baltic economies pride themselves of flexible labor markets with few
restrictions on hiring and firing and low unionization. Wages are also more
flexible than in most Western European countries. In the flagging
construction industry, for instance, salaries are already being slashed to the
half of last year’s levels according to some observers. In the first quarter of
this year, growth rates moderated in Estonia and Latvia but overall wage
levels were still up by healthy numbers compared to the same period of 2007.
In Lithuania, by contrast, wage growth took a rather brisk jump in the first
quarter of 2008. We accept the official argument that some of the recent wage
growth may reflect improved statistical recording, and that underlying wage
trends is smaller. In the case of Latvia, this statistical effect has been
estimated to about 7%, leaving actual Latvian wage growth in the first quarter
at about 20%. That is still almost certainly much higher than underlying
productivity growth.

The Baltic economies started the decade with strong labor cost
competitiveness
and for several
years high Debt/GDP
productivity
growth 160%
compensated 120%
rapid wages. 80%
Large scale
40%
emigration to the
EU as that 0%
Thailand
Philippines
Argentina

Hungary
Brazil

Czech

Poland
Indonesia

Lithuania

SouthAfric

Turkey
Taiwan
Chile
China

Malaysia
Mexico
India
Estonia

Russia
Korea
Latvia

opportunity
opened following
the EU accession
in 2004, was
evidence of a
significant wage gap, but more recent reports talk of a reversal of this
emigration and there has been some anecdotal evidence of workers from “old”
Europe finding interesting employment opportunities in the Baltic countries as
well, in particularly in the construction industry. That may indicate that
recent years’ wage hikes have eroded much of the original Baltic cost
competitiveness. Any further wage development out of line with competitors
would increase the pressure of finding new opportunities and niches for

3
Argentina had a dollar peg and currency board arrangement from 1993-2001. Indonesia had
a crawling peg to the dollar from 1991 to 1997.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

production of commodities and services that can be exported beyond the

scope of what can reasonably be expected in the near future.

The IMF recently calculated various measures of competitiveness for

Lithuania and concluded that the exchange rate was overall in line with
underlying competitiveness of that country. By contrast, in its latest report on
Latvia of late 2006, the IMF did not make a specific estimate of
competitiveness at the present exchange rate level for that country, but noted
that “..until recently Latvia enjoyed a modest competitiveness premium, but
recent wage and price developments had absorbed much of this initial
advantage.” As wages have risen by some 50% since then it is hard to believe
that the organization would have repeated its comment on competitiveness in
a similar soft language were it to make a new assessment today. 4 We fear that
the IMF might have concluded that labor costs in Latvia have grown too much
and that significant devaluation or deep cost cuts are needed to restore
competitiveness. The situation in Estonia appears more similar to Latvia than
Lithuania and the same concerns for that country might seem justified,
although perhaps somewhat less acute.

How long will markets

Gross wages support the imbalances? If
Annual growth in percent

the development already has

30 gone too far at least in Estonia
and Latvia, markets will at one
20
point in time begin to make a
new bet on devaluation, which
in the case of the existing
10 pegs: a currency board
arrangement in Estonia or a
0 currency peg with narrow
2004 2005 2006 2007
margins in Latvia (both
Latvia, Gross, LVL [ar 4 quarters] countries peg to the euro)
Estonia, Gross, EEK [ar 4 quarters] would be a one way bet
Lithuania, Gross, employees in the whole e ignoring the temporary loss on
Source: Reuters EcoWin

the likely higher interest rate

margin on local currency deposits.

One can identify five groups of market participants in the Baltic foreign
exchange and money markets of importance when considering the short to
medium term stability of the exchange rate arrangements in the Baltics.

o Foreign parent banks with large exposures. They may go at lengths to

support the exchange rate in order to ring-fence their local subsidiaries

o Tycoons of former Soviet block countries, who see Latvia in particular as

a safe haven for their money.

4
Latvia is on a ”regular 12 month consultation cycle” with the IMF but no new report has
been issued since October 2006. Such delays often indicate deep disagreements between the
national authorities and the IMF over how to describe the present situation and future
prospects.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

o Foreign companies and local individuals, who do not seek speculative

positions, but enter the foreign exchange market when they want to hedge
positions against negative exchange rate changes.

o Carry traders who seek higher returns from weak currencies as the local
authorities have to hike interest rates (or use other means to tighten
monetary conditions in the case of currency boards) to defend their
exchange rates.

o Foreign parent banks with small exposures in the Baltics.

The first two groups have for several years been the steady supporters of the
money markets in the Baltic countries. The foreign banks, at least those with
large subsidiaries in the Baltics, are unlikely to leave the markets
“voluntarily” and should have an interest in as little turbulence as possible to
give the countries a chance to restructure in a smooth manner.

The CIS-tycoons, in contrast, have little choice but to stay put, but could leave
in an extreme situation. They may be willing to take risk, but not any risks.
The noted investigation of the Latvija Bankas, however, may indicate that the
relevant Latvian banks have taken reasonable safeguards against a possible
run from non-residential depositors should it occur. That mitigates this source
of risk but does not eliminate it keeping in mind that these nonresidential
deposits represent 46% of banks’ total deposit base and that the relevant
banks may have changed their portfolio since the central bank investigation. 5
Interbank rates
Hedgers were apparently the guys who 13
stirred the markets in Latvia about a 12
11
year ago. They were scared by rumors
10 Latvia
over a weekend of individuals 9
changing their local currency cash at
% p.a.

8
hand into euros and dollars in forex 7 Estonia
bureaus which, in itself had only 6 ECB Lombard (ceiling) rate
5
marginal impact on market conditions.
4
Hedgers are likely to stay alert and 3 ECB Minimum bid rate
may react swiftly again. 2
jan maj sep jan maj sep jan maj sep jan maj
2005 2006 2007 2008
Carry traders are a new type of market Latvia, RIGIBOR, LVL Lithuania, VILIBOR, LTL
Source: Reuters EcoWin

participants for the Baltic countries. In other countries they have often
represented a positive speculative force, supporting currencies that other --
“professional” -- investors would have left long ago. However, they may be
scared by factors far outside the control of the Baltic countries, such as
increased volatility in their funding currencies. As such they represent a
significant vulnerability to market stability, as has indeed been the experience
of Iceland. The importance of carry trade for the Baltics is hard to assess as
this is apparently a rather recent phenomena, but they can probably be
thanked for some of the renewed stability of the local inter-bank markets. The
rapid expansion of some local Baltic banks into main Western European
capitals could be a part of a strategy to attract such deposits.
5
The report was published last week in Riga but as yet only in Latvian. We await the English
version before judging the results of this examination. One sticking point is if the test relates
to the banking system in aggegate or, preferably, to each individual bank with non-residential
deposits.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

The foreign banks with smaller exposures on the Baltic markets may represent
some kind of a wild-card. Until recently they were certainly attracted by what
seemed to be very good investments by the two major Swedish banks first to
enter the markets. In the present situation, however, as the fortunes appear to
change, they could use their positions to put spanner in the works for attempts
of the larger banks to manage overall credit growth. Having relatively small
exposures such behavior may not present much risk to their own finances,
while their positions in the Baltic markets are large enough to make a
difference, including in local money and currency markets.

All in all, the situation in the Baltic countries has become more complex with
new participants entering the market including carry traders. That may be a
new source of instability, but may also for a while support market equilibrium
provided calm returns to international financial markets and the three Baltic
countries are willing to pay a price attractive to the carry traders. The danger
is for this calm to delay ultimately needed restructurings of the Baltic
economies – i.e. to let the party go on for too long. But there is also a chance
this can give the authorities a respite to restructure without the duress of
financial market turbulence. The latter may still be a bit optimistic. As has
been the recent experience of other countries such hot money can leave as
quickly, or more quickly, than it comes leaving market equilibrium on shaky
grounds.

Market turmoil triggers. The market turmoil beginning February 2007 in

Latvia was followed by disturbances in Lithuania and Estonia toward the end
of the year. However, it is difficult to discern any common pattern through
these cases, and it may appear that
these events were triggered by rather
erratic behavior from various
categories of market participants.
More fundamental fear could arise if
markets were to perceive a threat of
one of the larger foreign banks heading
for the exit. The recent report from the
Swedish central bank, Riksbanken,
should help lay such concerns to rest.
It stated that none of them faced any
serious damage to their balance sheets
even in the case of severe shocks hitting the Baltic economies. Judged by the
share prices of the two banks, by contrast, the Riksbank report did not seem to
have much immediate positive effect on local investors. That could be
because it did little to allay investors concern over a new issue, namely
statistics from the Latvian banking association which shows a rapid increase
in overdue loans in recent months reaching 9% by the end of the first quarter.
So far this development in the total delinquency ratio has not affected the
level of non-performing loans (NPL), which is loan payments overdue more
than 60 days and the official measure of “bad“ loans. At 0,5% of total assets
NPLs still remain low by any standard. The point is that any increase in
“light” delinquencies could have a lagged effect on real delinquencies, i.e.
“NPL”, some months down the road. In Latvia the total delinquency ratio
reached about 9% at the end of the first quarter of 2008. The equivalent
number for Estonia was 5%. The latter is reportedly dominated by a few large
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SEB Merchant Banking Country Risk Analysis June 21, 2008

loans that could have turned sour regardless of the circumstances. The sheer
size of the Latvian numbers for Q1 seems to preclude such an explanation.

Third: Where does this point?

Having adopted pegged exchange rates and even combined with currency
boards in two of the three Baltic countries, until quite recently many market
participants believed that nothing could go wrong, even though the memory of
Argentina should not yet have faded completely. Unfortunately the rigors of
such kind of exchange and monetary policy regimes were forgotten in the
ebullient environment that reigned in the first few years after the Baltic
countries’ EU accession in 2004 and in global financial capital markets in
general. For these policies to succeed, fiscal policy would have had to be kept
much tighter than was the case, even though by normal standards, including
the Maastricht criteria, fiscal policies were prudent. Tighter fiscal policies
would have helped reduce overheating, kept wage and price inflation in check
and enabled governments to accumulate larger reserves to meet shocks should
they occur anyway. Unfortunately, politicians of these countries seem to have
been beset with the notion of “convergence”, that is to bring living standards
up to Western European levels at a pace that disregarded any speed limits.

For Latvia and Estonia many observers seem to agree that a soft landing
scenario is no longer an option, and the discussion is about degrees of hard
landing. The question is if Lithuania has been a quick learner and is now able
to slam the breaks in time. With a general election waiting this fall these may
not be the best of times for telling people to stop spending. The danger is
therefore growing by the day that Lithuania will follow in the footsteps of its
two northern neighbors within the next year or so.

A hard landing scenario will most certainly include some kind of a

devaluation. In a best case scenario that could be a so-called internal
devaluation, meaning severe wage restraint, increased labor market flexibility
and labor productivity. Many people will have to accept longer work hours
and wage cuts, not least in the government sector where groups of employees
apparently have received excessive salary raises. Such have been the bitter
medicine swallowed by other countries including Hong Kong and Germany in
the recent decade, but eventually these policies have succeeded. This means a
gradual process that could take up to a decade to complete and which would
require a significant and immediate reduction of peoples’ income
expectations.

The other option is an external devaluation, which again has two sub-options:
• Controlled devaluation
• Devaluation enforced by markets
The first would be the preferred choice if combined with economic adjustment
programs for example under the auspices of the IMF. The second would more
likely than not ensue excessive overshooting. In the case of Argentina the
pesos fell by more than 70% when the currency peg to the dollar broke in
2001, much more than the 25% overvaluation estimated by many observers
prior to the event. A similar scenario for the Baltic countries could spell
disaster. Most bank loans -- on average some 80% of the total, are in euros,
more than was the case in Argentina. A steep devaluation could force many
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SEB Merchant Banking Country Risk Analysis June 21, 2008

debtors to default, reducing the stigma of doing so. At the end the Baltic
countries might come to carry the stigma of unreliable debtors for years to
come.

We think that the Baltic countries should realize that they have come to the
end of the road and that they need to engage a new strategy. For one thing:
“fast-track conversion” should be abandoned as any operational policy goal.
Second: It should be realized that in the absence of tough policies to maintain
competitiveness and if needed to restore competitiveness through internal
devaluations, the pegs have outplayed their roles as policy instruments and it
may be a matter of time before they loose credibility. Effort should also be
directed at designing policies that can cushion any economic downturn. In this
sense it is important that policy makers refrain from dogmatism and allow
automatic stabilizers of fiscal policy to function within reason.

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SEB Merchant Banking Country Risk Analysis June 21, 2008

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