The economies of the Baltic region notched up eye-popping double-digit growth rates, fuelled by cheap credit often supplied by western banks and strong capital inflows triggered by European Union accession in 2004. As a result, Lithuania ran a current account deficit of 12.5% of GDP last year while its gross external financing burden stands at around 155% of international reserves.
But as capital inflows into emerging markets began to plummet in the last quarter of 2008, Lithuanias economy contracted by 1.5% compared to 2.9% growth the previous quarter. Analysts suggest the economy could shrink by around 3% to 5% this year, raising doubts about whether the governments belt-tightening measures, announced in December to reduce the fiscal deficit to 2.1% of GDP this year, will succeed.
Politically, its hands could be tied after violent protests swept Lithuania as well as Bulgaria, Latvia and Hungary last month. Demonstrators were protesting at government austerity measures. But Andrius Kubilius, prime minister of the Republic of Lithuania, is defiant and pledges that policy flexibility will be unhindered.
"We are in a permanent monitoring of the global situation and after the first quarter of the year, we could make additional cuts, in addition, to other economic measures," he told EuroWeek in an interview in Vilnius this week.
But sharp contractions in capital inflows and the monetary base could inflict a deep and painful recession that will erode public finances across the region. This would also hit the asset quality of western banks and further reduce economic growth. In this case, there is a thin line between a regional recession and the prospect of a wholesale financial crisis sweeping eastern Europe. The spectre of a regional domino effect was raised at the end of last year when neighbouring Latvia as well as Hungary were given a total of $18bn in IMF loans.
But Kubilius, the head of the Homeland Union-Lithuanian Christian Democrat party, denied that a domestic financing crunch was imminent in Lithuania.
"For the time being we are quite sure we can manage to avoid the possibility of going to the IMF," he said. But, he could not rule out the prospect of an economic shock that could precipitate a balance of payments crisis in the future. "At the same time, after reading sources of financial information, I am feeling a lack of optimism about the global situation."
Nevertheless, he saw no stigma of accessing funds from the global policy lender and reiterated the virtues of the country having such options available.
The government relies on global capital markets for external borrowing due to the illiquidity of its domestic securities market. However, the country was prevented from issuing a Eu400m Eurobond at least once last year due to a lack of demand.
Nevertheless, its external debt repayment schedule is clear until 2012 when a Eu1bn Eurobond matures. If a sharp domestic slowdown erodes national revenues, the government may try to issue bonds.
In the near-term, Kubilius is seeking multilateral support to finance a moderate economic stimulus package with cash from the European Investment Bank, the Nordic Investment Bank and European Community funds to boost the real economy.
"We need to create another channel for our businesses to get access to the credit market and push additional money supply into the market," he says.
But ultimately, Lithuanias economic fate lies in the hands of Scandinavian bankers. While the strong foreign banking presence in the region was long seen as net benefit since it reduces contingent liabilities for Baltic sovereigns, the downside has now been exposed. Engulfed by the western financial fires, parent banks are now repatriating capital away from their eastern European offspring to shore up their balance sheets and they are under political pressure at home to offer scarce liquidity to domestic markets.
Scandinavian groups, led by SEB and Swedbank, dominate the banking system in Lithuania and Kubilius admits that abrupt credit contraction could imperil macro-economic stability. "It is a big problem to convince parent banks that it is business as usual."
After 50% annual credit growth between 2003 and 2007, 2008 saw only 20% expansion while this year, zero credit growth is on the cards.
A widespread loss of depositor confidence contributed to a net deposit outflow of 6.5% last October alone. In response, Lithuania has upped the limit of bank deposit guarantees to Eu100,000.
Some analysts suggest that as non-performing loans increase, asset quality deteriorates and refinancing costs rise, some weaker foreign banks could even pull out entirely.
EuroWeek revealed in November that some eastern European authorities are lobbying the European Central Bank to provide temporary currency swaps to non eurozone states.
In addition, the central bank is under pressure to consider accepting non-euro denominated government bonds as eligible securities for its repurchase transactions with parent banks. This is crucial since western banks supply foreign exchange to their eastern European subsidiaries via such short-term instruments. Kubilius explained that bilateral discussions with the ECB and the Swedish government on such issues were taking place.
He said that global financial institutions, western countries and Baltic governments have a mutual interest in seeing credit flow freely else over-exposed banks could incur large losses in the region. This would create a negative feedback loop by exacerbating financial instability in parent markets. "I think it is just obvious that it is of common interest for Sweden and the Baltic states to have economic and financial stability by dealing with this banking issue," he said.
In recent years, borrowers have issued euro-denominated credit in anticipation of eurozone convergence and buoyed by the stable and fixed currency peg to the euro. Foreign currency-denominated loans accounted for 63% of loans to the non-bank private sector in November 2008, according to Fitch.
The Lithuanian lit is subject to Exchange Rate Mechanism II the requirement to lock the national currency into a narrow exchange-rate band against the euro for at least two years before entering the common currency.
As a result, the country does not have an independent monetary policy and the exchange rate cannot act as a shock absorber against capital volatility and external pressures. A painful and abrupt adjustment in wages, nominal prices and a jump in foreign currency debt servicing costs are therefore expected as the economy contracts.
In response, some eastern European central bankers have openly criticised such aggressive lending by western banks and have suggested a regulatory cap on the proportion of foreign currency credit to reduce systemic risks. European banks have been "irresponsible" with such lending practices and "borrowers should realise that exchange rates can be volatile" Serbias central bank governor told Emerging Markets last year.
But Kubilius denied such regulatory measures were necessary. "We have a primary goal to introduce the euro so we are OK with the large number of euro loans." He categorically denies the currency could be devalued and argued the country was on track to adopt the euro in 2012.
In May 2006, the European authorities rejected the countrys bid to join the eurozone after missing the inflation target by a hair. Kubilius regretted this decision.
"It is a big pity that we missed the target by such a small percentage of inflation and if we were part of the euro-area, it would be easier for us to survive all these difficulties," the former chairman of Lithuanias parliamentary committee on European affairs.
European integration has forced regional economies to fully open their capital accounts and chain their currencies in line with eurozone convergence. As a result, the systemic risk of incurring current account deficits, to some extent, was difficult to avoid as regional economies played catch-up with their western neighbours.
Against this backdrop, some Baltic policymakers, in recent months, have expressed frustration that western counterparts appear reluctant to help their neighbours, distracted by the global banking meltdown.
Kubilius suggested that the European Commission should consider relaxing its strict criteria on euro adoption in this environment. "Both the commission and ECB people should look more carefully on how to provide effective solidarity in trying to solve the problems of the transition members of the EU members of the family and all supportive measures, including the possibility of relaxing a bit of the Maastricht criteria, [for euzozone convergence] should be considered".
Nevertheless, he denied that the crisis risked damaging the post-cold war belief that integration with western markets was a guarantee of economic security. "People are blaming national governments for their economic problems right now and if you look at places like Iceland and Ireland, we are seeing a more positive agenda with respect to calls for deeper European integration."