Baltic economies have recovered quickly, but investments remain behind the curve

The Baltic countries have been commended for a quick adjustment of labour costs, increase in efficiency, and repair of public sector finances, all of which contributed to a successful recovery from the crisis. All three countries went through a painful internal devaluation and were able to come out of the crisis through a spectacular growth of exports. However, investments remained behind the curve, especially in Lithuania. This might impede competitiveness and the growth potential in the future.

Companies have deleveraged significantly, but they still face some credit constraints. Companies claim that the efficiency of financial markets in Lithuania is smaller than in the other Baltic countries. Investment in R&D and attracting FDI poses challenges as well.
Research suggests that one of the most effective ways to increase investments is to not tax the reinvested profit. This would also make a country more attractive for FDI. In addition, heavy labour taxation and rigid labour markets are detrimental to investments. Finally, more efficient government spending and regulation are needed.

During the recent financial and economic crisis, the Baltic economies were among the most severely affected – as real estate and consumption bubbles deflated, output contracted by 16-24 percent from peak to trough.
Nevertheless, competitiveness was restored through internal devaluation, and the countries rebounded forcefully as exports increased well above the pre-crisis levels.

Lithuania’s export volumes in the second quarter of 2014 were 40.4% higher than the pre-crisis peak; Latvia’s (in the first quarter of 2014) and Estonia’s export was higher by 19.4% and 29.6%, respectively.
The recovery of the economies was export driven. Exports as a share of GDP increased significantly in all three countries compared with 2007. It increased from 67.1% in 2007 to 87.7% last year in Estonia, from 42.5% to 59.7% in Latvia, and from 53.8% to 86.9% in Lithuania.

The collapse in household consumption, which before the crisis had been fuelled by a rapid increase of financial leverage, was one of the main reasons behind the deep recession.
Household consumption has recovered since, but remains about 10% below the pre-crisis peaks in all three Baltic countries. With the job market recovering, household consumption will increase steadily in the coming years and will be much less volatile.

However, the investment recovery has been delayed by weak confidence even though companies have decreased their leverage significantly; capacity utilisation in Latvia and Lithuania is back to the pre-crisis highs and interest rates have dropped to historic lows.
Investments remain well below the pre crisis level (in Lithuania; e.g., in the second quarter of this year they were 20.3% lower than in 2007). However, a comeback to the pre-crisis level is neither likely nor needed, since irrational exuberance caused companies to overinvest heavily in 2006 and 2007 – in Latvia and Estonia, gross fixed capital formation amounted to around 35% of GDP.

More than half of investments during the peak were to dwellings and other buildings and structures. However, the largest share was recorded in 2009 as investment in transport and other machinery and equipment decreased more than investments in dwellings and other buildings and structures.
The share of investments to dwellings and other buildings and structures has decreased since then by about 10 percentage points in Estonia and Lithuania, and by 2 percentage points in Latvia.

Overall, despite the 2008-2009 setback, the Baltic countries’ convergence towards the EU average has been rapid. Labour productivity per hour worked in Lithuania increased from 49.9% of the EU average in PPS (purchasing power standard) in 2004 to 66.4% of the EU average in 2013. Over the same period, Estonia’s productivity rose from 48.5% to 61.4%, and Latvia’s from 36.5% to 56.9%.However, further progress and convergence will almost certainly be slower. Many EU countries – the Czech Republic, Malta, Greece, the UK, Italy, Finland, Sweden, France, Netherlands, Belgium, and Luxembourg – have lost some productivity in relation to the EU average in a decade. But this is not an option for the Baltic countries – they need to raise productivity in order to raise living standards, curtail emigration, and lessen the pressure of aging populations on public finances. Productivity can be increased through structural reforms and improvements in the institutional environment, education, and, finally, investments, especially foreign direct investment (FDI), which allow for spill-overs and technological transfers.