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Fitch: Lessons From the Baltic States for the Euro Area Periphery

Date

2011 08 25

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Fitch Ratings-London-25 August 2011: In a newly published report, Fitch Ratings examines the parallels between the experience of the Baltic States' (Estonia, Latvia and Lithuania) economic adjustment and return to growth and the current situation in the euro area periphery.

"Estonia, Latvia and Lithuania faced severe economic crises in 2008-09 and have shown that although it was painful to correct large macroeconomic imbalances and return to growth with a fixed euro exchange regime, it was not impossible," says Michele Napolitano, Associate Director in Fitch's Sovereign team.

"However, parallels appear overall to be much closer with Ireland than Greece or Portugal, due to its more flexible labour market, open economy and attractive business investment environment," adds Napolitano. In all six countries, current account deficits soared in the years prior to the crisis, mainly as a result of rapid growth in credit and domestic demand combined with a rise in unit labour costs relative to main trading partners.

The Baltic States have unwound their large external imbalances through domestic demand contraction, a decline in inflation and wage growth relative to trading partners. This "internal devaluation" was a painful process: these countries suffered a cumulative real GDP contraction of 18% in 2008-09. However, in 2011 their economies are recording fast rates of GDP growth, driven by a strong export performance. External competitiveness and confidence in their solvency have also been restored.

With a fixed nominal exchange rate, the peripheral euro area countries can only gain competitiveness over the medium term if they allow price and wage levels to decline. Indeed, the IMF-EU programmes advocate this type of adjustment to restore competitiveness in those countries. However, as Fitch has noted before, this will be extremely challenging.

Some of the lessons from the Baltic States are that severe macroeconomic adjustments are more likely to succeed where economies are open and flexible, the authorities undertake decisive and early fiscal austerity measures including cuts in public wages, there is strong social cohesion and political consensus behind austerity, and external support is provided to underpin confidence in banks where necessary.

Today's report focuses on Greece, Ireland and Portugal which have EU/IMF programmes, although some of the lessons are also relevant to Spain. Entitled "The Euro Area Crisis: Lessons from the Baltic States", it is available at www.fitchratings.com


Fitch report