Published on April 13, 2008
ECONOMY OF THE BALTIC STATES: ECONOMY OF THE BALTIC STATES The 1998 Russian crisis and its impact on the economies of the Baltic States Russia’s Transformation: Russia’s Transformation One-party rule Formal central planning Fixed-price system Small income differences Little capital mobility Multi-party rule Market economy Large wealth disparities Capital mobility BEFORE AFTER Roadblocks to Russia’s Transformation: Roadblocks to Russia’s Transformation Continued threat of hyperinflation Lack of private domestic investment Persistent fiscal imbalances Inadequate legal framework for a market economy Russia’s Soviet Era Debt – Paris Club: Russia’s Soviet Era Debt – Paris Club Source: Russia’s Paris Club Debt: US Interest; Congressional Research Report, John Hardt, July 2000 Russian External Debt: Russian External Debt Source: Russia’s Paris Club Debt: US Interest; Congressional Research Report, John Hardt, July 2000 An attempt to remedy the situation: An attempt to remedy the situation 1995: IMF-supported stabilization program -tightened monetary policy -nominal exchange rate target -shift from inflation tax to bond and bill financing RESULT: price and exchange rate stability, but no structural or institutional reforms Peculiarities of the Russian Financial System: Peculiarities of the Russian Financial System Property Rights Multi-Currency Economy Intertwining of Economic and Political Decision-Making Property Rights: Property Rights Mass privatization (1992-94) -concentration of wealth -insider ownership Lack of entrepreneurial spirit Lack of domestic lending by banks Multi-Currency Economy: Multi-Currency Economy Wide-usage of barter in business-to-business transactions -of industrial output: 5% in 1992 46% in early 1998 Use of offsets Quasi-monies Dollarisation Intertwining of Economic and Political Decision-Making: Intertwining of Economic and Political Decision-Making Elite interests -interest groups make policy Widespread corruption Poorly developed and implemented commercial & corporate law Cynical constituents What went wrong?: What went wrong? Bad Luck Bad Policies Bad Institutions Bad Luck: Bad Luck Importance of Commodities While exports declined, imports continued to increase dramatically. Current account deficit Asian Crisis - Investor confidence - Trade partners Bad Policies: Bad Policies Rouble overvalued Tax revenue insufficient to cover outflows Financial market issues Inadequate risk management Poor monitoring of Central Bank Market overestimate Central Bank’s abilities Bad Institutions: Bad Institutions President given too much control before crisis began Short-termism Political instability Central Bank and Ministry of Finance conflict Internal corruption So What Happened?: So What Happened? Capital investment left country Equity prices plunged Higher interest rates did not stop outflow of funds Privatization Insufficient tax revenue New debt and reserves used to fund deficit What did Russia do?: What did Russia do? At the beginning widened the band on the fixed exchange rate Central bank tried to defend the rouble, but eventually had to let rouble float = devaluation Central bank reserves were reduced Monthly inflation = 45% Default on debt – State treasury bonds (GKO) and the repayment of interest on the Paris Club debt 90-Day Moratorium on repaying private foreign debt to save core banking system Government Revenue, Deficit and Fiscal Policy: Government Revenue, Deficit and Fiscal Policy Low revenue - Low output - Tax concealment - Decrease in the price of oil A large amount of foreign debt came due in 1998 Only alternative under fixed exchange rate regime was to deplete its foreign reserves Monetary Policy, Financial Market and Interest Rate: Monetary Policy, Financial Market and Interest Rate To prevent a currency crisis, the CBR intervened twice to decrease money supply and increase interest rate - exacerbated the debt problem - preventing firms from obtaining loans Stock market plummeted Effect of Rate Hikes: Effect of Rate Hikes Source: <http://red-stars.com/financials> The Exchange Rate: The Exchange Rate Source: IMF (end of period data) Foreign Reserve Depletion: Foreign Reserve Depletion Source: Central Bank of Russian Federation Results: Results New exchange rate corridor lasted a few days, then exchange rate floated and ruble sunk fast to 20 per dollar. By May 1999 the rouble had lost 70% of its pre-crisis value. Loss of investor confidence from default Loss of confidence within banking system Russian banks losses = 40% of assets Immediate Economic Aftermath: Immediate Economic Aftermath Real GDP decreased by 4.9% in 1998 vs. expected small growth Real income of the population decrease by 25% in 1999 Imports decreased by 50% in 1999, current account was positive Foreign capital continued to leave the country Inflation mounted Effect On GDP: Effect On GDP Source: Russian Statistical Committee and International Bank of Reconstruction and Development. Effect On Current Account: Effect On Current Account Source: Central Bank of Russian Federation Effect On Capital Account: Effect On Capital Account Source: The Central Bank of the Russian Federation Effect On Inflation: Effect On Inflation Source: IMF After the crisis: After the crisis Successful negotiations with Paris and London Club creditors Negotiations with the IMF Reform in banking system Financial position of the open sector improved International image deteriorated - ranked 161 among 180 countries for country risk Source: 1999 Euromoney survey Baltic States and the Russian Crisis: Baltic States and the Russian Crisis Russia has historically been an important trading partner for the Baltic States (at least since WWII). Russia was also an important source of imports, especially imports of energy resources. The provision of transit services for Russian trade was also an important source of income for the Baltic States. The Russian crisis of 1998 led to a reduction of exports, a fall in demand and an economic recession in the Baltic States. It was only in the second half of 1999 that the Baltic States slowly began to recover from the recession, which had begun in the 4th quarter of 1998. Exports of Baltic Countries in the First Seven Months of 1998 and 1999: January–July 1998 January–July 1999 % change in the value of exports (local currency) Value % of all Value % of all (millions of $) exports (millions of $) exports Estonia Exports to Russia 288 15.0 142 9.0 -45.4 Exports to entire CIS 447 23.2 217 13.8 -46.1 Exports to EU 1,000 52.0 973 61.8 8.0 Total exports 1,927 100.0 1,575 100.0 -9.2 Latvia Exports to Russia 168 15.3 67 7.0 -60.0 Exports to entire CIS 249 22.6 110 11.3 -55.8 Exports to EU 578 52.7 616 63.6 6.6 Total exports 1,097 100.0 968 100.0 -11.8 Lithuania Exports to Russia 419 21.4 121 6.9 -71.1 Exports to entire CIS 850 43.4 324 18.5 -61.9 Exports to EU 661 33.7 873 49.9 32.1 Total exports 1,957 100.0 1,750 100.0 -23.8 Source: BOFIT. Exports of Baltic Countries in the First Seven Months of 1998 and 1999 Baltic States and Foreign Trade: Baltic States and Foreign Trade In Latvia and Lithuania Russia was the leading trading partner prior to the crisis, and in Estonia Russia was one of the top three trading partners. The effect of the Russian crisis on Belarus and the Ukraine also affected the foreign trade of the Baltic States. Especially in Lithuania, where Belarus and the Ukraine in 1997 were 19% of total Lithuanian exports. Baltic States and Foreign Trade: Baltic States and Foreign Trade Baltic States and Foreign Trade: Baltic States and Foreign Trade The main effect of the Russian crisis in foreign trade was in respect of the exports for the food processing and other manufacturing industries. For example: - Estonia: the largest manufacturer of milk products was forced to lay off 300 workers for two months and to lower the price of milk. - Latvia: A/s “Laima” prior to the crisis had mainly orientated its exports to the CIS – 73% to Russia. After the crisis in 1999 only 10% of exports were to Russia. - Lithuania: the third largest packing material manufacturer was forced to close for a month already in September 1998. 600 workers were forced to take leave for an indefinite period. Dynamics of the volume of production of manufacturing industries in the Baltic States* (quarterly profile, percentage change against the respective period in the preceding year): Dynamics of the volume of production of manufacturing industries in the Baltic States* (quarterly profile, percentage change against the respective period in the preceding year) In the above table the largest fall in the volume of production was in Latvia – for two quarters in a row the volume of production was more than 16% less than the relevant indicator in the previous year. In Estonia the volume of production since the second half of 1999 already exceeded the relevant indicator in the previous year and in the 1st quarter of 2000 was 16% higher than in the previous year and had nearly reached the pre-crisis level. In Lithuania only in the 1st quarter of 2000 was it possible to reach a higher volume of production than in the previous year with a significant growth of 9%. In comparing with the pre-crisis period – the 1st quarter of 1998, the volume of production in the 1st quarter of 2000 in Lithuania exceeded the pre-crisis indicator by 1%, in Estonia by just less than one per cent, however in Latvia the indicator was 14% less than for the same period in 1998. * pēc Baltijas valstu statistikas datiem Employment in the Baltic States: Employment in the Baltic States The labour market in each of the Baltic States reacted differently to the reduction in the volume of production. In all of the Baltic States the effect of the Russian crisis at the end of 1998 and the beginning of 1999 the registered level of unemployment grew by 2-3 percentage points, but by the middle of 1999 this fell slightly. In Latvia the unemployment level continued to fall, but in Lithuania and Estonia at the end of 1999 – beginning of 2000 a “second wave” of growth in unemployment was observed. Baltic States and the financial sector: Baltic States and the financial sector The bank sector in the Baltic States had comparatively little direct involvement with Russia. Investments of Estonian and Lithuanian banks in Russia were only approx. 1% of their assets. In Latvia it was different, with over 8% of the banking system’s consolidated assets being invested in Russia. The Latvian banking sector was negatively affected by the economic crisis in Russia and as a result several banks in the second half of 1998 were in a serious situation. One small bank (Viktorija) was closed and Latvia’s fourth largest bank “Rīgas Komercbanka” had liquidity problems. The effect of the Russian economic crisis had reduced the total assets and deposits of banks and most banks in Latvia finished 1998 with losses. Baltic State securities market indexes*(1998 January = 100, index in relation to the beginning of the month): Baltic State securities market indexes* (1998 January = 100, index in relation to the beginning of the month) In the spring of 2000 a seasonal growth in the price of stocks in the Baltic States securities market was observed, but the indexes for April and May again fell in all the Baltic States. Even though Estonia was able to approach the pre-crisis level, which began a couple of months prior to the Russian crisis, the indexes for all the Baltic States are much less than the indicators for the beginning of 1998. * Based upon Baltic States stock exchange data GDP Growth Rates in the Baltic States*(quarterly profile, percentage change against the respective period in the preceding year): GDP Growth Rates in the Baltic States* (quarterly profile, percentage change against the respective period in the preceding year) The GDP indicator for the last quarter in 1999 for Latvia and Estonia already exceeded the relevant result for the previous year, however, the fall in the Lithuanian GDP in the second half of the year continued to fall. * statistical data of the Baltic States Latvia and the Russian crisis: Latvia and the Russian crisis In the second half of 1998 and the beginning of 1999 the complex economic situation in the world as a whole and especially in Russian also affected the rate of development of the Latvian economy. Due to the Russian economic crisis, in this period : - the volume of Latvian exports and industrial production decreased, - the indicators for the activities of banks worsened, - the volume of budget revenue did not meet estimates, and - unemployment increased. Latvia and the Russian crisis: Latvia and the Russian crisis The volume os of the manufacturing industries fell substantially in 1999 (nearly 10% - mostly in the food processing and chemical industries). However, in other sectors, primarily those orientated to Western markets, such as wood and wood products, metals and clothing, manufacturing activity grew. There was substantial reduction in agriculture, the proportion which in the GDP fell each year and in 1999 was only 2.4%. Due to the Russian crisis in the second half of 1998 and the first half of 1999 many Latvian undertakings had to dismiss workers. Due to the Russian crisis the total level of investments in 1999 was lower than in 1998. From the middle of 1999 the negative effects of the Russian crisis on the development of the Latvian economy were slowly being overcome. Conclusion: Conclusion Even though the main reason for the downturn in manufacturing in all the Baltic States was the Russian crisis and the associated reduction in the export of goods and services to that market, the impact of the crisis on various economic sectors in the Baltic States was different because of the effect of other, mainly internal factors. In 1999 only Latvia managed a small increase in the GDP of 0.1%. In Estonia GDP was 1.1% lower than in 1998, but in Lithuania it was 4.1% lower. Trade began to turn even more intensively to the West, partly because the purchasing power of Russia had fallen dramatically. The Russian crisis showed that the Baltic States are small, open economies, which are very sensitive to external shocks.