"Afteryears of strong, and ultimately unsustainable, growth fuelled bymassive capital inflows and rapid credit growth, a necessary slowdownis underway in the Baltic economies. However, the downturn is sharp inEstonia and Latvia and they are at risk of recession, heighteningdownward pressure on creditworthiness," said Eral Yilmaz, AssociateDirector in Fitch's sovereigns group.
Real year-on-year GDPgrowth has plummeted to a negative 1.4% in Q208 in Estonia from 4.8% inQ407 and to just 0.2% in Latvia from 8.1%. The slowdown in Estonia andLatvia has been led by a fall in investment, particularly into realestate, and private consumption, which has also slowed import growth.Credit growth has weakened and property prices have fallen around 20%in the past year. Lithuania's economic boom was more modest and,consequently, its imbalances are less marked. It is also experiencing aslowdown in real GDP growth, although it started later in Q307 andgrowth was 5.5% in Q208.
Furthermore, inflation rates are high,wage growth is robust and external finances remain over-stretched. At16.5% in July 2008, Latvia's year-on-year inflation rate was thehighest in the EU while, Lithuania's (12.4%) and Estonia's (11.2%) werethe third- and fourth-highest, respectively. Fitch forecasts Latvia'scurrent account deficit at 18.2% of GDP in 2008, the second-largest inthe EU, Lithuania's at 14.5% and Estonia's at 12.7%.
"An orderlyunwinding of macroeconomic imbalances would likely lead Fitch to revisethe Outlooks back to Stable," says Ms Yilmaz. However, that depends onthe confidence of residents and foreign banks, continuing financing forthe current account deficit and prevention of the spike in inflationfeeding into higher price expectations, as well as on how quickly wagegrowth will moderate and on whether industry can restructure toincrease exports."
A recession or protracted slowdown,particularly in conjunction with persistent high inflation,deteriorating competitiveness, and problems in the banking sector, ordevaluation of the Baltic currencies - which is not Fitch's centralscenario - would likely lead to a downgrade.
The ratings of allthree Baltic states are underpinned by their strong public finances andlow government debt ratios, Fitch believes. Estonia's government debt burden was just 2.7% ofGDP in 2007, the lowest in the EU and among 'A' range credits; Latvia'swas just 10% and Lithuania's 17%. Furthermore, all three countries arenet public external creditors. The high level of ownership of thebanking system by Nordic banks, which Fitch believes are committed tolong-term investments in the Baltic countries and will continue toprovide support to their Baltic subsidiaries, is also a rating strength.
However,a prolonged downturn would have a detrimental affect on budget balancesand bank asset quality and could undermine confidence, while thefragile global environment adds to financing risks. Fitch believesdevaluation is unlikely, but not impossible if the downturn proves longand deep and if there were loss of confidence in the Baltic currenciesand their banking systems, triggering a widespread conversion andwithdrawal of deposits.