The Galerija Centrs shopping arcade in downtown Riga is a fitting symbol of Latvia’s transformation from a former Soviet republic to the fastest growing state in the European Union.
The once dowdy department store – opened in 1938 on the eve of the Soviet occupation – is now a western-style mall, with a lofty glass arcade, escalators, international brands and even a spa. Eight million shoppers – more than three times the country’s population – visited last year.
The smart districts of the old Hanseatic port of Riga are also being transformed. Crumbling Art Nouveau mansion blocks have been renovated, sold and now stand empty while their speculative buyers wait for prices to rise further.
EU accession in 2004 has stimulated growth in all three Baltic states, with structural funds adding to the construction boom in the capitals.
At the same time, migration westwards has pushed up domestic wages and, when money is brought back, added to house price inflation.
“For decades we never had these possibilities,” says Irena Krumane, state secretary at the Latvian finance ministry. “Young people are faced with aggressive media advertising pressure and they want to have everything today.”
The speed of this growth – particularly in Latvia – as well as its structure are also worrying international rating agencies. Standard & Poors put Estonia on negative outlook this week after doing the same to Lithuania in May and downgrading Latvia to BBB+ with a negative outlook.
Growth has been driven by domestic demand, with rising wages and soaring lending sucking in imports and pushing up inflation and house prices.
Wage growth, at about 20 per cent a year, is well above productivity increases. This is swiftly eroding industry’s competitiveness at a time when imports are already growing much faster than exports.
The overheated figures have dashed the Baltic states’ hopes of entering the eurozone early. Lithuania’s move to adopt the euro was rebuffed at the start of this year.
Inflation is now well above the limit in each country and all have dropped their ambitious entry dates and have no official target. Most analysts regard entry as unlikely before 2012.
Nevertheless, the danger facing all three states comes not so much from a collapse of foreign confidence – there is not much speculation in Baltic currencies and the banking sectors and public finances remain solid – as from the impact of any sudden change in consumer behaviour as expectations of continued future growth are dashed. This could lead to a collapse in house prices and a steep economic slowdown.
Such a “hard landing” could stop the three EU newcomers in their tracks as they struggle to catch up with western Europe. Even Estonia, the richest, is still only two-thirds of the EU average gross domestic product (GDP) per capita.
A rapid slowdown could also create a lot of red ink on the balance sheets of Scandinavian banks whose subsidiaries have done so much to stoke the Baltic boom. “The banks are absolutely responsible for the situation here,” says Ms Krumane, who complains that they are focusing on lending to consumers rather than export companies.
Banks have begun imposing stricter credit policies, lending growth is slowing down (though it is still rising at 40 per cent a year) and customers are starting to save more.
“We’re trying to communicate to the market the need to be cautious – don’t run if you don’t need to,” says Audrius Ziugzda, chief executive of SEB in Vilnius.
Growth in house prices, domestic demand and GDP is slowing but wages, inflation and current account deficits are responding more slowly.
“It is looking increasingly likely that there will be a hard landing,” says Kenneth Orchard of Moody’s, the most sanguine of the rating agencies. “Even if growth just falls sharply, it will feel like a recession.”
The central banks have few tools at their disposal to bring the economies down gently because their currencies are pegged to the euro or managed by currency boards. Fiscal policy must, therefore, shoulder the burden but in all three countries weak governing coalitions find it difficult to restrain spending at a time of fast economic growth.
Since the run on the Lat in February, the Latvian government at least has tightened credit rules and spending and postponed plans for cutting taxes next year (unlike Lithuania and Estonia) but no country is taking advantage of soaring revenues to build up significant budget surpluses.
So far the central banks have shied away from making tough statements because of the risk of triggering an over-reaction. The risk is that by the time they decide they have to speak out, it may be too late.