Baltic Economies and Financial Crisis in the EU

Abstract

The aim of this paper is to specify those features of the three Baltic economies that explain why they were the countries worst affected by the 2008-09 financial crisis.There was a clear divergence among the new EU member countries prior to 2007: while three Central European countries relied on FDI as the main type of foreign capital inflow, Hungary relied mostly on portfolio inflows and Baltic economies relied mostly on other investment.The paper demonstrates that credit booms characterized the dynamic economic growth of Baltic economies from 2001 through 2006. A distinct feature of the credit booms was a large share of household loans in foreign currency. Credit expansion in the Baltics that was funded by large borrowing from foreign parent banks helped to create property bubbles, which proved unsustainable even before the 2008-09 financial crisis in the EU.The case of Baltic economies after 2007 illustrates the vulnerability of open economies that are over-dependent on large foreign capital inflows (not in the form of long-term FDI).This paper also points out the following specific features of Lithuania and Latvia. With a relevant share of FDI in manufacturing, Lithuania had a more balanced structure of bank loans to the private sector and a lower level of household indebtedness. With the lowest level of foreign bank ownership, Latvia's case demonstrated how domestic banks become the ones most vulnerable to liquidity risk. After Parex Bank was nationalized in December 2008, Latvian foreign reserves decreased significantly and the country had to apply for IMF-led financial assistance. Latvia is the only Baltic country without a currency board, thus its fixed exchange rate came under the most pressure.Scandinavian banks in the Baltics have taken several measures to strengthen their capital base, which implies that foreign banks (unlike Latvian Parex) can cope with economic downturn in these countries, and that they are committed to their Baltic subsidiaries.In the future, policy decisions in response to credit booms will be conducted within the new EU regulatory and supervisory framework. From a long-term perspective, more FDI into tradable sectors could provide Baltic economies with more balanced and sustainable economic growth.