RIGA - The World Bank has joined the rising chorus on possible economic overheating in the Baltic states, saying in its January report 's EU8+2 's that "strong wage and credit growth are leading to overheating and significant inflationary pressures." The World Bank's assessment appeared just two weeks after The Economist, the prestigious British magazine, wrote that "growing imbalances" in Latvia's economy have increased the risk of a "hard landing."
The World Bank concurs, though it says the same holds true for all three countries. The international finance institution defines overheating as a situation where "productive capacity with existing labor, capital and technology is unable to keep pace with growing demand without putting sustained upward pressure on prices."
The bank says that "signs of overheating are mostly clearly seen" in the Baltics in rising core inflation, real exchange rate appreciation, upward wage pressure, and an asset price bubble.
The picture, to be sure, is not rosy. A persistent labor shortage and high wages, with easy credit, and a favorable taxation regime, has sparked what has been described as an asset bubble in the real estate sector.
These two trends converge in the construction sector, where demand for new housing is robust but contractors are pressed to find laborers to do the work. In Latvia, construction costs grew 25 percent last year, including a 41 percent increase in wages and a 15 percent growth in materials.
As the World Bank points out, the Baltics scored the highest annual rises in hourly labor costs in the EU25 based on third quarter 2006 data 's Latvia (up 24 percent), Lithuania (20 percent) and Estonia (17 percent).
Externally, all three countries have seen their current account deficits increase and their external debt (as a percentage of GDP) rise, particularly in Estonia and Latvia.
The bank writes that there are two scenarios for the Baltics. Either domestic demand will subside or it will continue to grow, which will lead to "a sudden loss of confidence resulting in banks pulling out, a sharp correction in asset markets and a collapse of growth."
To prevent the latter scenario, the World Bank recommends
1) "reversing the current pro-cyclical fiscal policies" by increasing public saving and discouraging private borrowing;
2) strengthening supervision of banks;
3) continuing structural reforms in labor markets to make them more flexible, including more inward migration;
4) bolstering investor confidence by implementing credit euro-adoption plans, which include reigning in inflation.
