Fallen Stars
The first, tentative signs of economic recovery are starting to appear in Germany and France. In Poland, too — buoyed by strong domestic demand — the economy grew in the second quarter. All this raises hopes that, one year on, the worst of Europe's gut-wrenching recession may be nearing its end. Yet there's still one corner of the continent where the idea of a return to growth remains a distant dream: in the Baltic republics of Lithuania, Latvia and Estonia.
The three tiny states broke away from the crumbling Soviet Union almost two decades ago, and for much of the interim, they have served as poster children for the successful transition from communist state planning to free-market capitalism. Their soaring economies — between 2001 and 2008, growth ranged between about 7% and 10% a year — were bolstered by the three states' accession to the European Union in 2004. Their people are a lot better off: based on purchasing power, the per capita GDP in all three republics has about quadrupled over the past two decades. But even before the Lehman debacle, all three economies were showing worrying signs of overheating, fueled in part by real estate speculation and heavy borrowing abroad.
Those bubbles popped a year ago. Lithuania's economy contracted by a jaw-dropping 20% in the second quarter of this year — one of the worst performances in the world — after a 13% decline in the first quarter. Latvia (-20%) and Estonia (-17%) weren't far behind. In all three countries, exports are way down, unemployment is soaring and government budgets have swung sharply into the red. Latvia is in the worst mess. It received a $2.4 billion bailout from the International Monetary Fund last December, but that wasn't enough to shore up its shaky finances; in late August, the IMF formally agreed to another emergency lifeline of $278 million.
While each republic has its own specific problems, all three have reacted with a stout defense of their currencies accompanied by massive cuts in public spending. The pain has been enormous. Health care, education and other social spending were among the first items slashed. At one hospital in Riga, the Latvian capital, patients arriving for treatment outside set working hours are now being turned away, even at the emergency department. "We will be the villains, even though this is not our fault," says Andrejs Pavars, chairman of the hospital's board. Domestic consumer spending has collapsed. New car registrations in the region are down by as much as 80% this year.
Lithuanian President Dalia Grybauskaite, whose English is otherwise impeccable, talks about the economy's "downfall" when referring to the downturn, and that lapse speaks volumes: the onetime highfliers have been humbled. In an interview with TIME, Grybauskaite says 2010 will continue to be "difficult," with recovery coming at the earliest in 2011. The only good news — if you can call it that — is that "this year we'll probably hit bottom."
The Baltic blues are more than just another tale of recession woes. The three states — and especially Latvia — are now the battleground for a wider ideological struggle over how vulnerable countries should best react to violent economic swings. In one corner are the IMF and numerous economists, who believe that the best course for the Baltic republics would be a classic one: currency devaluation. That's how much larger countries, including Britain and Italy, bounced back from economic hard times in the 1990s. But the Balts themselves, backed by the E.U., are fiercely opposed to devaluation. Since joining the E.U., their long-term economic strategy has been tied to adopting the euro.
Devaluation, local policymakers argue, would not just wreck their best-laid plans, but would also bring a host of new problems for a very short-term benefit. In particular, a substantial portion of government and private-sector borrowing in all three states is in foreign currency, so a devaluation would automatically send debt levels soaring. Proponents of devaluation say that it would give a much needed boost to exports, and thus help rekindle economic growth. But its opponents argue that the Baltic republics' main export markets — larger nations in Western Europe — are moribund, so it would take more than cheaper goods to boost trade. Devaluation, of course, might quickly make the states more competitive in terms of labor and other costs — potentially attracting foreign investment. But because they've stuck with their existing euro exchange rates, "investors are very hesitant to go in at the moment," says Erik Berglöf, chief economist of the London-based European Bank for Reconstruction and Development (EBRD).
The gloom is not unremitting. Massive current-account deficits in all three states have rapidly swung into surplus, as imports have been slashed. And after months of being frozen out of international credit markets, Lithuania has managed to start borrowing again — albeit at extremely high interest rates. Yet there are still dangers, and not just to the Baltic countries themselves. Swedish banks piled into the region over the past decade to become its biggest domestic lenders, and have been hit by the "downfall" as a result. In late August Swedbank, which is one of the most exposed Swedish banks, announced a $2 billion rights issue to shore up its balance sheet, its second this year.
Chewing over the lessons of the crisis, Raimondas Kuodis, chief economist of the Lithuanian central bank, says previous governments should have put aside more when the good times were rolling. Instead, "the previous government spent every penny it had and at the end of the year, Lithuania was standing naked," he says. President Grybauskaite, a former Finance Minister who has spent the past four years in Brussels as an E.U. Commissioner, concurs: "The economic cycle," she says, "became the political cycle." Berglöf of the EBRD sees a much bigger failure in regulation. More should have been done to crack down on the rapid expansion of lending, especially in foreign currency, he says.
Whoever is to blame — and the collapse of world markets undoubtedly played a huge role in the Baltic problems — all three republics see a much brighter future if they can just pull their finances together over the next few years and join the euro as fully fledged members of the currency union. President Grybauskaite says she expects that the Baltics could start the formal process of joining the common currency in about 2013. But for the moment, such talk is premature. "Talking about the euro now is like people on the Titanic discussing what they'd do if they were back in New York," says Kuodis of the central bank. "First we need to get through the next two to three years of this economic crisis." And that will mean a lot more painful belt-tightening.