How the Baltics melted down

RIGA, Latvia and VILNIUS, Lithuania — In the Baltics, the specter of three “D’s” are stalking the land: devaluation, default and destabilization.

Eastern Europe is in economic turmoil. Among the countries where the bite has been the largest are the three former communist states of Estonia, Latvia and Lithuania, which joined the European Union and NATO in 2004. Just a few years ago, they registered some of Europe’s highest growth figures, earning the moniker the “Baltic Tigers.” Now they are again setting new records — but this time in the loss column.

The causes of the implosion are many and include a confluence of external and internal factors. EU membership opened up the Baltics' markets to foreign investment and banks, while providing them outlets to export to. When the going was good, banks lent readily, governments ran huge deficits and a number of economic bubbles emerged — most prominently in the real estate, retail and construction sectors. Even at the height of the boom, analysts were warning that the growth was unsustainable. Now, however, with the global downturn, external markets have disappeared, while banks ­— a large number being local affiliates of Scandinavian ones — have cut off credit lines.

“Money was available, credit was cheap and people thought that the honeymoon would go on forever,” said Kestutis Sadauskas, the EU’s representation head in Lithuania. “The market was totally unsaturated.”

“The money went into business, but often not into the right ones. There was no value added,” he continued.

Latvia’s economy will contract this year by a heart-stopping 12 percent, says the country’s finance ministry — the largest potential drop in the 27-member EU. Others say it could be even more. Paul Krugman, the American Nobel Prize economist and New York Times columnist, called Latvia “the new Argentina” in a December online discussion.

Estonia is better placed economically to weather the storm, analysts say, having socked away financial reserves during the fat years. Nevertheless, its gross domestic product may shrink between 5 and 9 percent, while unemployment will rise considerably. Lithuania’s economic figures will drop somewhere between those of Latvia and Estonia.

Throughout the Baltics, the gloom is manifest. Nearly all of the region’s seven million inhabitants seem to have been affected by the crisis one way or another — either directly through a job loss or salary reduction, or something similar within their immediate circle. In Riga, empty shop fronts dot the main streets, their dirty, grey windows with “For Rent” signs gaping into the darkened streets.

Some believe that worse is yet to come. Though their dread may be exaggerated, the threat is nevertheless there. Devaluation of the local currencies is the first concern. All three countries pegged their currencies’ exchange rates to the euro, in hopes of entering the EU’s euro zone in just a few years’ time. Now, however, as their economies plummet, central banks are coming under increasing pressure to abandon the pegs and let their currencies float at will — de facto devaluation — so not to use up all their reserves.

Latvia, with its incredible shrinking economy, is the most likely candidate for a worst-case scenario. The effect on the population could be devastating. Locals are paid in lats, the national currency, but financed their cars, homes and businesses in dollar and euro-denominated loans. (Ninety percent of loans were in foreign currency last year.) Devaluation would mean that untold numbers would not be able to meet their payments.

Next is the risk of default. All three Baltic countries have seen their credit worthiness downgraded by international ratings agencies, with Latvia being relegated to junk bond status. The price of credit default swaps — the bet that investors make that a country or its institutions will default on their loans — are increasing, with Latvia leading the pack.

And then there is destabilization. Should any of the Baltic economies collapse, the others could very well be brought under as well. Devaluation in Latvia for instance would most certainly lead to a similar scenario in Estonia and Lithuania, who would not be able to compete with their neighbor’s cheaper currency. Default would most certainly affect them in the same way, and probably jolt other European nations, especially in Scandinavia.

Not least among possible consequences is the political fallout. Latvia and Lithuania have already witnessed major demonstrations, which descended into violence, against the austerity programs that their governments introduced to deal with the crisis. Latvia’s center-right coalition government fell last month, and Estonia’s recently survived a no-confidence vote. Anger and frustration is rising among the populace. Those guiding their governments are viewed as corrupt, incompetent or indifferent.

“It’s clear that sharp falls in living standards are inevitable this year — I just hope that people accept it,” said Peteris Strautins, chief economist for Swedbank in Riga.

But any doomsday scenario still may be a long way off, even if the Baltics undergo considerable pain in the near future. Latvia has received a 7.5 billion euro rescue package from the IMF and other institutions, while Sweden and Estonia’s central banks late last month agreed to a $1.1 billion currency swap to help bolster the Estonian kroon. Most importantly, the Baltic governments, though slow in reacting initially, are now on the right track, some analysts say.

“It’s been a real roller coaster ride, but I’m not scared,” said Strautins.

More dispatches by GlobalPost correspondent David L. Stern:

Opposition to Georgia's president emerges

Why the air base debate drags on

Manas Air Base: A Pyrrhic victory?

For more on the global economic crisis:Click here for the full report