Swedbank: Baltic Outlook

Swedbank just released its latest Baltic Outlook (full version of the report you will find here), and the key message by Maris Lauri is a s follows:

As global economic processes continue to worsen, it is rather unlikely that the current global crisis, which some have called the Great Recession, will find its bottom this year. Nevertheless, most forecasts (e.g. IMF) expect that in 2010 the US economy and then Europe will start a gradual and slow recovery. It is extremely unlikely that the three Baltic countries will start recovery earlier than the global trend, although there might be some aspects (e.g. lower production costs), which could, if adequately addressed, help the economies recover sooner or at the same time as other regions. But the current economic processes in the Baltic region and investors’ attitudes towards it are pointing to a lagged and painful recovery. Still, some economic processes may stabilize (i.e. not become worse) by the end of 2009 or early 2010.
We expect a very deep recession in the three countries this year: the Latvian economy is expected to fall by 15%, the Lithuanian by 13% and the Estonian by 10.5%. The next year may bring growth in Estonia (according to the optimistic scenario by ca 0.5%), but a slight decline is more likely. The Latvian and Lithuanian economies are forecast to decline 4% and 3%, respectively. So the first year of growth will be 2011 and even then it will be not impressive.
The economies are heavily affected by fallen external demand, and extremely weak domestic demand, which suffers from low confidence, growing unemployment, wage cuts, and the credit squeeze. All three economies have entered a painful adjustment process, which should end up with a more competitive and effective corporate and public sector. Estonia has gone through a bigger part of the adjustment process. Latvia faces the most challenges, while Lithuania entered into recession only at the end of 2008 and therefore may still have a relatively long way to go. However, the dire economic situation makes the adjustments swifter and more painful.
The adjustment process in economies has substantially lowered misbalances therein, and as the process continues, the misbalances, if they still exist, will be eroded very quickly. We expect consumer price inflation to slip into the negative side this year in Estonia and Latvia. Lithuanian consumer prices are forecasted to grow this and next year as some administrative factors remain strong (or are not yet unsolved) while the country replaces its electricity generation to the more expensive form (i.e. nuclear energy will be replaced with fossil fuels due to the closure of Ignalina NPS).
External balances have also improved rapidly and we expect the process to continue, so that Estonia and Latvia will see close to a balance or surplus in their current accounts this year, and the Lithuanian deficit will be substantially lower than in
previous years. The foreign capital inflows will diminish considerably, and private sector flows will turn (i.e. assets are returned and liabilities diminished). As of now, only Latvia is about to face a substantial increase in foreign debt due to the IMF Stand-by Arrangement.
Domestic financial sectors are already or are on the brink of the deleveraging process as foreign capital inflows are scarce, domestic savings low (but household savings growing), and pessimism in the corporate and household sector is high. The process will be rather intensive, and the level of non-performing loans will continue to increase, but we do not expect it to reach extremely high levels.
Governments of three countries have found themselves in a particularly difficult position: fragmented political landscapes, elections and alienation from the public have made the changes painful, having a lot of setbacks and hurdles. Governments have to make cuts in spending at the same time as other countries apply supportive measures, as the financing of the budget gap is very expensive or impossible. Only Estonia has reserves for covering the budget deficit, but without changes in the spending the reserves could be exhausted by mid-2010 or earlier. So the government policies are actually making the economic situation worse (cutting employment, wages, subsidies, etc) although they are targeted to create fiscal prudence and stabilize public sector finances. The latter is important due to continuously poor external perceptions, which has pushed up risk margins, scared investors off and forced some of them to leave, thus making developments for the corporate sector extremely difficult and pushing the prospect of economic recovery further back. However, on the positive side we can expect that the productivity and efficiency of the public sector will improve strongly.
We do not expect changes in current monetary policy, i.e. the currency systems in the three countries will remain as they are now until the Euro adoption. Devaluation will not be a solution for existing problems and would create other, more serious
problems, having also a spill-over effect on other economies (e.g. CEE, countries with substantial exposure to the CEE financial markets). We are of the opinion that Estonia has a window of opportunity for entering the Euro zone in 2011, but the government has to make very serious efforts to use this opportunity. The prospects for Latvia and Lithuania are in a more distant future (after 2012).