Theme: The changing Baltics
In addition to inflation, the Ukraine war and related sanctions are also hampering growth in the Baltics. Given their geography, it is easy to assume that Russia’s neighbours Estonia, Latvia and Lithuania are among countries losing the most from the situation. Since the war started, we have revised our forecasts lower − but perhaps not as low as expected. The economic links between the Baltics and Russia are less important than many people believe. Years of uneasy relations with an increasingly autocratic Russia have forced the Baltics to diversify their economic and political risks. The outcome is reduced dependence, especially for exports. This is why today commodity shortages and supply side disruptions, rather than loss of Russia as an export market, are causing problems.
Although Russia's full-scale invasion of Ukraine came as a shock to most, it was less surprising for many people in Estonia, Latvia and Lithuania. History and geographic proximity have contributed to a high level of worry but also of awareness. After 50 years of Soviet occupation, Estonia, Latvia and Lithuania regained their independence in 1991 and since then they have been vigorously working to protect themselves from history repeating itself, for example by joining NATO and the EU to hedge political as well as economic risks.
Decreasing their economic dependence. Trade is often heavily dependent on geography, with neighbours typically being major trading partners. But although Estonia, Latvia and Lithuania share a total of 780 km of border with Russia, direct economic ties between the countries are not as close as one might think. This has not always been the case, but various economic and political shocks in recent decades have confirmed that doing business with Russia entails political and economic risks that the Baltics are not prepared to take.
The latest turning point was Russia’s 2014 occupation of Crimea, but earlier events such as the rouble crisis of 1999, the conflict between Estonia and Russia in 2007 after the removal of a Soviet monument and Russia’s invasion of Georgia in 2008 have also contributed.
Trade statistics overestimate Russia’s importance
The impact of current sanctions against Russia on the Baltic economies may be more limited than statistics show. In 2021, 11 per cent of Lithuanian, 7 per cent Latvian and 4 per cent Estonian merchandise exports went to Russia. However, only a small fraction of these goods was produced in the Baltic countries. In Estonia and Lithuania, where more detailed statistics are available, domestically produced goods accounted for less than 2 per cent of total exports to Russia. Instead most were transit exports – goods that only passed through these countries on the way to their final destination. While transit export volumes have benefited the wholesale and logistics sectors, the value-added from such services tends to be low. Looking at exports of goods, excluding re-exports, Lithuania is actually more exposed to Ukraine than to Russia, in which case both logistical constraints and lower demand might be challenging.
Russian energy imports can be replaced
In 2021, goods from Russia accounted for 12 per cent of total imports to Lithuania, 10 per cent to Estonia and 9 per cent to Latvia. Here, too, the figures may be somewhat misleading, since crude oil and refined petroleum products accounted for 60 per cent of total Baltic imports from Russia. Latvia and Estonia previously re-exported Russian oil to other countries. The only oil refinery in the Baltics, in Lithuania, has now stopped oil purchases from Russia and switched to other suppliers. As for natural gas, Estonia and Lithuania have said that they will stop such purchases from Russia, relying fully on liquefied natural gas (LNG). Latvia is expected to follow suit next year. Lithuania has had a functioning LNG terminal since 2014 while Estonia, together with Finland, plans to set up facilities to receive LNG vessels in the coming months in Paldiski, Estonia − a project that might later be joined by Latvia.
Loss of Russian imports a concern for manufacturers
The situation is more concerning for the region’s large wood processing sector and metal industries, which have previously imported a substantial part of their production inputs from Russia. Estonia and Latvia are two of the most forested countries in Europe, so there is no direct shortage of raw materials, although prices may rise. Substituting Russian metal input will be more complicated. But at higher prices, steel and iron can also be sourced from other countries. Although a lot of imports from Russia are thus replaceable, this will lead to higher raw material prices, which in turn will have a negative effect on margins and exacerbate the already rapid rise in construction prices. Another sector that will be adversely affected is agriculture, which will face a shortage of imported fertilisers.
However, the biggest economic problem for the Baltics right now is that the war is broadly driving up commodity prices and ultimately consumer price inflation. Compared to the wealthier Nordic countries, the share of food and energy in Baltic consumer price indices is much higher. In Sweden the share of food in the HICP basket is 14 per cent, while the corresponding figure in Estonia and Lithuania is 19 per cent and in Latvia 23 per cent. Energy, which makes up less than 10 per cent of household expenditures in Sweden, accounts for 13 per cent in Lithuania and 16 per cent in Latvia and Estonia. On the other hand, all three Baltic countries are net producers of food, which secures their food supply and benefits many companies.
Living standards are now on par with southern Europe
Although the income level of the Baltic countries is still less than half that of Sweden, years of rapid economic growth have significantly raised the standard of living. In 1995, purchasing power parity-adjusted per capita GDP in the Baltics was just over 30 per cent of the EU27 average. Today the corresponding figure is almost 90 per cent in Lithuania and Estonia, surpassing Spain and closing in on Italy. Latvia, which suffered the most in the global financial crisis, has a somewhat lower GDP per capita but shares a similar trend with its Baltic peers.
Loss of Russian transit flows restructured economies
Along with the growth in welfare, significant changes have taken place in the structure of the Baltic economies. In Latvia and Estonia, these changes are linked to the diminishing economic relations with Russia. The volume of Russian cargo passing through these countries has declined over the years, reducing the size of their logistics and storage sectors. Both countries have also experienced a gradual decline in manufacturing as a share of GDP. In the 1990s, manufacturing made up around 20 per cent of total value-added, falling to around 12 per cent in Latvia and less than 15 per cent in Estonia by 2021. Both countries are also notable for very low manufacturing productivity. One reason is that many big Nordic companies own production units in the Baltics, while higher value-adding services such as product development and sales stay in their country of origin.
A shift to service economies
As a general trend, the role of services has increased in the Baltic economies over the past decade. Lithuania has been very successful in developing its transport sector, taking advantage of its geographic location. Lithuania has also been able to retain a higher share of manufacturing in GDP and thus higher productivity than its Baltic peers. As in many other countries, the role of the IT and tech industry has been increasing in the Baltics. The biggest gains have been made in Estonia, where the information and communication sector has risen to almost 9 per cent of total value added, surpassing such industries as construction, transport and storage.
Migration trends are changing
One of the biggest problems for the Baltic countries has been emigration, which intensified especially in the years right after the global financial crisis. Latvia and Lithuania have lost more than 20 per cent of their populations since 2000. Estonia’s population decline has been only 5 per cent. This is related to their differing migration patterns. While Latvians and Lithuanians looked for work far from home – in countries like the UK or Germany − Estonians were more likely to commute weekly to neighbouring Finland. Today the situation has dramatically improved. Net migration turned positive in Estonia in 2015, with Lithuania following in 2019. In Latvia outflows continue to exceed inflows, but this trend seems likely to reverse in the near future. A large share of inward migration has consisted of Baltic citizens returning home, but rising standards of living have also started to draw more people from other countries.
The Ukraine war is reshaping labour markets
The rapid economic growth of recent years has made the Baltic labour markets extremely tight. This has forced companies to seek employees from abroad. One important source of foreign labour in recent years has been Ukraine. This has relieved labour shortages in the construction sector, but increasingly also in manufacturing and IT. When the war started, many Ukrainian men left the Baltic countries to defend Ukraine. Instead the Baltics have now welcomed a large number of Ukrainian women and children fleeing the war. By the end of April, Estonia and Latvia had each accepted around 25,000 refugees and Lithuania almost 50,000. Many of these refugees have been remarkably successful in finding jobs. Hopefully this may continue to alleviate some of the previous Baltic labour shortages.