Economic growth slowed down significantly in all three Baltic countries in the first quarter of 2015. However, the Latvian economy proved to be the most dynamic among the Baltics, particularly due to export resilience in the context of falling trade with Russia.
Exports most resilient in Latvia
Being heavily dependent on the Russian market, the Baltic economies have been the first to feel the economic crisis in Russia. Estonian exports to Russia in real terms contracted even more than Russian imports – by 47% and 34% respectively. Taking into account the 15% contraction of exports to Russia in 2014, this appears to be an issue of both demand and supply, i.e. Estonian producers are increasingly giving up on the Russian market deeming it risky and unpredictable. Latvia, on the other hand, proved most resilient to the Russian shock. In real terms its exports to Russia contracted by 26%, while in the case of Lithuania the contraction was 30%.
The aggregate effect of such a fall in exports has not been the same among the Baltics. As Russia is the single most important export partner for Lithuania, having accounted for more than 20% of Lithuanian exports before the current crisis in Russia, the shock is naturally greatest for Lithuania. Mainly due to the Russian factor, overall Lithuanian exports in real terms expanded by a mere 0.2% in the first quarter of 2015. Exports in Estonia and Latvia expanded by 3% and 5% respectively. This was more than the growth in imports, which implies that the trade balance of Estonia and Latvia improved during the period.
Consumption remains the key driver of growth
Driven by rising wages, low oil and fuel prices as well as the general decline in prices, consumers in all three Baltic states have been on a spending spree lately. This trend was less marked in Lithuania, where retail trade grew by 3.7% after a very active December, when consumers spent significantly more than usual in light of the uncertainty regarding the upcoming introduction of the euro. In Estonia and Latvia the opposite trend happened – after a relatively slow end of the year, consumers seem to have gathered pace in the beginning of 2015. Retail trade grew by close to 8% in both countries in the first quarter of this year.
Average inflation in the first quarter was for the most part negative in all three countries. As long as the deflationary trend is perceived as temporary by the consumers, it serves as a catalyst for consumption. In the coming months we expect a pick-up in inflation throughout the euro area, including the Baltic states. This will have a mitigating effect on consumption, but the growth in real wages, which is expected to average 4-5% in all three countries this year, will ensure that private consumption remains the key driver behind economic growth.
A slowdown in investments
Geopolitical tension has had a strong effect on business confidence in the Baltics. Despite the expansion in retail trade, services and industrial production, business confidence in these sectors has been declining recently in all three countries, but especially in Estonia and Latvia, where business confidence is at the lowest since the 2008-2009 crisis.
This has had a direct effect on the appetite of businesses to invest. In both countries investment growth was negative in the second half of 2014 and is likely to have stayed negative in the first quarter of this year as well.
The situation is somewhat different in Lithuania, which has suffered from underinvestment in recent years. Capacity utilisation in Lithuania is highest in the Baltic region and close to its record high levels, reached in 2007. This has kept the pressure on businesses to upgrade machinery and equipment and was the factor which allowed Lithuania to avoid investment contraction over the previous quarters.
The economic outlook
Going forward, we expect growth to accelerate in all three economies in the second half of 2015 and into 2016. The key unknown remains geopolitical tension. If the international political situation improves, this will have a positive effect on business confidence and investment growth. As the Russian economy reaches the bottom in the second quarter of this year, exports to Russia should also recover, at least partly.
We maintain our growth forecast for all three economies in 2015 at 2.2% for Estonia, 2.6% for Latvia and 2.5% for Lithuania. We expect growth to pick up in 2016 to 2.9% in Estonia and 3.2% in both Latvia and Lithuania.
The writer is a Baltic Analyst at Danske Bank