Estonia ahead

Baltic economies

The Estonian exception
Oct 29th 2009 | RIGA AND TALLINN
From The Economist print edition


Estonia gets a boost, but worries persist about its Baltic neighbours
SMUGNESS is Estonians’ least attractive feature, at least in the eyes of their Baltic neighbours, Latvia and Lithuania. A surprise endorsement by the International Monetary Fund of Estonia’s plans to join the euro in 2011, coupled with gloom about the other two countries, will only make that worse.

All three Baltic states are facing double-digit economic declines in GDP this year, following the collapse of credit bubbles created by reckless lending and spending. Many outsiders have wondered if the three countries can maintain their fixed exchange rates, which peg the national currencies to the euro. A currency or banking collapse in the Baltic would spook markets elsewhere in the region, threatening wobbly economies such as Hungary’s.

So for the past year the focus has been on averting disaster. Plunging tax revenues made the chances of any Baltic states meeting the criteria for joining the euro look slim. In Latvia, for example, the government is struggling to keep next year’s budget deficit down to 8.5% (see chart)—a condition for the continuation of a €7.5 billion ($11 billion) IMF-led bail-out package. To join the euro, the deficit must be sustainably below 3%.



But it now looks as if, barring upsets, Estonia by the middle of next year will have met all the criteria for joining the euro. Inflation is low; government debt is negligible (indeed the country still has net public assets) and next year’s budget sets a deficit of 2.95%. That is thanks, the IMF says, to Estonia’s thrifty habits in public finances. The government has cut spending hard and early. It sped through modernisation projects financed by the European Union. This acted as an economic stimulus. Latvia and Lithuania have found it much harder to follow the same path. Lithuania has dodgy banks and spiralling debts; Latvia has lost credibility among outsiders because of its failure earlier this year to cut spending as promised.

For safety’s sake, the IMF still wants Estonia to raise and broaden taxes a little. Car-owners, for example, pay no car or road tax. But Andrus Ansip, the prime minister, already feels vindicated. He says the prospect of euro adoption will boost investors’ confidence and speed the country’s recovery.

Attention now shifts back to Latvia, where the IMF and EU are holding up a new budget, due to be passed on October 28th. They worry that the precarious governing coalition lacks political will, and that the crisis is unfairly hitting the poor. They want Latvia to dump its flat tax for a more progressive system. But Latvia says higher taxes would discourage entrepreneurs and that chaos in the state revenue office means that the higher rates would bring in little extra cash. No reason to feel smug there.