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
"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
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
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
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
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
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."