The economies of Estonia, Latvia and Lithuania
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Having gained independence from the Soviet Union, the trading relations of the three states radically changed their focus towards the west, a process that accelerated after the 1998 Russian economic crisis. All three are members of NATO and the WTO and, since 2004, the European Union. But their large eastern neighbour, Russia, still exerts significant influence in a range of areas. Estonia and Latvia, and to a lesser extent Lithuania, have sizeable Russian-speaking minorities, and their position in society has caused some tensions. Having among the lowest per capita incomes in the EU they have some catching up to do, and are doing this rapidly with very high growth rates. Shorter-term challenges revolve around entry preparations for the euro area; for the longer term, choices must be made on where they can be competitive and which new industrial sectors should be developed. EU Structural Funds and Lisbon national reform programmes will support them in meeting these challenges. Human capital will also play an important role here. All three have high participation in tertiary education but these skills are often unsuited to industry’s needs and emigration of workers compounds this situation. Coherent policy responses will be required to ensure a successful transition to the knowledge economy.
Joining the euro area
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In a major step towards entering the euro area and adopting the single currency, Estonia and Lithuania both joined the exchange rate mechanism (ERM II) in June 2004, and Latvia followed in May 2005. All three have made remarkable progress in aligning their institutions and economies with the euro area and are taking steeper convergence paths than other new Member States. In general, as the Baltic States chose strict monetary policy regimes that leave little leeway within ERM II, it is important that fiscal policy and structural reforms aim at stability in the medium term and avoid a pro-cyclical bias in the policy mix. Estonia and Lithuania are aiming to enter the euro area in 2007, Latvia in 2008.
Estonia
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The northernmost of the three countries, Estonia faces Finland across the Baltic and there are strong historical ties between the two countries, with similarities in their two languages. With the Estonian capital Tallinn less than 90 minutes’ journey by fast ferry from Helsinki, there are growing economic links, and the two regions have established a ‘Euregio’ partnership to boost economic interaction. Estonia’s ambitious National Reform Programme plans to raise R&D spending from 0.82% in 2003 to 1.9% of GDP by 2010, and recognises the need to upgrade low-productivity sectors that have provided growth but will come under increasing pressure in the context of globalisation. Raising employment is a further challenge and a range of measures are being undertaken to attract and retain more people, and more skilled people, in work. Estonia is unique in the EU in generating a significant share of power from oil shale found in the northeast of the country. However, this share is decreasing, for environmental reasons, and Estonia is becoming more dependent on Russia for natural gas imports.
Economic priorities
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As the Commission assessment of Estonia’s convergence programme states: with a balanced budget, the lowest debt in the EU and low age-related expenditure risks, Estonia can be held up as an example of good fiscal policy. Over the past decade, growth has averaged 6%, well above the EU average of 1.7%. In common with its neighbours, this rapid growth is accompanied by a high external deficit driven by investment and consumption – around 10% of GDP in Estonia’s case. While this is an expected feature of the catching-up process, it is an imbalance in the economy that is being financed by strong inflows of foreign direct investment and supported by a prudent fiscal policy, which has produced surpluses. Ireland, which has served as a model for Estonian policy-makers, also experienced a similar external account deficit while catching up. While macroeconomic stability and convergence are high priorities for Estonia, reducing taxes on labour and investing to promote R&D, innovation and training will also be important to ensure that maximum advantage is gained from inward investment for the country’s future.
Latvia
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Situated between its Baltic neighbours, Latvia has experienced rapid economic growth since 2000, supported by one of the highest productivity growth rates in the EU. GDP per capita reached 43% of the EU average in 2004, yet remains the lowest in the Union. Unemployment is high and has only recently fallen below 10%. Like its neighbours, a low cost base attracted much of the early foreign investment that helped economic growth. As incomes rise, it will be critical to manage the switch to more knowledge-intensive sectors, and the Latvian National Reform Programme lays the basis for this with clear ambitions to raise R&D expenditure and create the framework for a coherent innovation system. On employment, the NRP seeks to reduce regional disparities and match skills with labour market requirements through upgrading the provision of education in engineering and sciences and vocational training. Although Latvia has natural resources such as timber, limestone and gypsum, services, including banking and transit, are major contributors to GDP. In the future knowledge economy, forestry services and chemicals and biofuels derived from Latvia’s agricultural and forest resources may prove a significant industrial sector.
Economic priorities
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Like its neighbours’, Latvia’s recent economic performance has been robust. However, to ensure sustainable convergence en route to the euro area a reduced external deficit is desirable and inflation, which is the highest in the EU at 6.9% in 2005, must be contained. While Latvia has low government debt and a small deficit, medium-term economic performance is a subject of particular focus for policy-makers. Rapid economic growth over the past years has helped keep government deficits low while allowing investment in structural reforms, such as the pension system, which contribute to the sustainability of public finances in the longer term. However, the external deficit and high inflation pose non-negligible risks that must be carefully managed to maintain stable convergence, support the desirable investments planned under the National Reform Programme, and maintain investor confidence. Latvia, in common with the other two Baltic States, has created a flexible and business-friendly environment that encourages investment. A further improvement to this environment, and an economic priority, involves measures targeted at lowering the tax burden on labour.
Lithuania
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The southernmost and most populous of the three Baltic States, Lithuania is the only one whose capital, Vilnius, is inland from the Baltic Sea. Of the three Baltic States, Lithuania has the highest share of trade with Russia today. In the Soviet era, Lithuania was an important energy centre and remains so today. Large oil-refining operations contribute significantly to GDP and Lithuania exports electricity to its neighbouring countries from its nuclear power plant Ignalina. The recent closure of one reactor has hit exports, but this blow is softened by strong activity in most economic sectors. Linking in to EU energy networks is a priority for Lithuania to reduce dependence on Russian energy.
Economic priorities
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Macroeconomic performance has been strong over the past years, with very strong economic growth underpinned by both investment and private consumption. Other positive aspects are falling unemployment and relatively low inflation compared to its neighbours, although the latter is rising largely due to higher oil prices. High growth and improved tax collection over recent years have helped keep the government deficit low. Improving the business environment is an economic priority to ensure the continued flow of foreign investment that supports growth and helps reduce the external deficit. Personal income tax reform is also targeted to reduce the tax on labour, encourage employment and lower inflationary wage pressures. While this may reduce government revenues in the short term, longer-term benefits for employment and activity rates are expected. Public investment in upgrading the energy efficiency of housing is a further priority that will reduce dependency on oil supplies and stimulate the domestic economy through creating a market for these services.
