Baltics: Small, Open Economies Face Highest European Inflation; Underlying Credit Resilience Intact

Soaring inflation is a widespread challenge for many economies. However, for the Baltics, the challenge is especially acute. Inflation in August was running above 20% YoY, more than 10 times the ECB inflation target.

Specifically, inflation stood at 24.8% for Estonia (rated AA-/Stable), 22.4% in Lithuania (A/Positive) and 21.6% in Latvia (A-/Positive), in all three cases more than double the euro-area average of slightly above 9%.

Inflation is set to average 17-20% for the year (Figure 1) across the three economies, before dropping by around a half by next year, as base effects improve, to still unusually elevated levels.

Figure 1. Inflation among euro area countries

% YoY, August 2022 (or most recent month available)

High Vulnerability to Inflation Results in Sharp Economic Slowdown

The Baltic economies are especially vulnerable to current inflationary pressure in view of comparatively higher shares of energy and food items in their respective consumption baskets, which reflects, among other factors, the Baltics’ still relatively lower income levels vis-à-vis that of euro-area peer economies. As prices for energy and food have soared since escalation of the Russia-Ukraine war, inflationary pressure has risen significantly.

Such high inflation holds adverse consequences particularly for small economies such as those of the Baltic region, notably for social stability via eroding purchasing power and savings, creating regressive redistribution among different income groups as well as between creditors and borrowers. Inflation also creates uncertainty for businesses around future costs and prices, which deters investment.

The economic impact of soaring prices on businesses and households is visible in the region’s slowing economic growth. Output contracted in the second quarter across the Baltic region, between -0.5% and -1.3% quarter-on-quarter. We expect annual growth to remain moderate this year – between positive 1% and 2% for Estonia and Lithuania and around 2.5% for Latvia.

The headline annual growth figures are deceptive as they reflect a carry-over from the robust economic growth at the beginning of the year. The economies face a sharp slowdown during the second half of 2022. Next year, growth will slow further but we do not expect full-year contraction. However, fuller recovery will be delayed to 2024.

Limited Solutions to High Price Pressures Ahead, but Solid Fundamentals Cushion Ratings

The ability of the ECB to curtail high inflation appears especially limited in the case of the Baltics despite the 75bp rate hike last week, and this is not only due to a dominant role of supply-side factors in current inflation.

Although inflation in the Baltic region is far higher than euro-area averages, the ECB focuses its monetary policy on average inflation of the single currency area, inherently skewing policy toward its largest member states. As such, ECB policies remain overly accommodative for inflation conditions in smaller Baltic economies.

Also, demand-driven inflation is stronger than in other euro-area member states, after comparably modest economic contractions in the Baltic region during 2020 Covid-19 crisis peaks, which were swiftly followed by robust recoveries. Tight labour markets are likely to favour longer-lasting inflation risk, as vacancies remain high and unemployment rates low even after recent inflows of Ukrainian refugees.

Moreover, Baltic governments are under growing pressure to step up budgetary support to alleviate price pressures on businesses and households, although such support – depending on its overall volume and target – might further contribute to underlying inflation dynamics.

However, the three countries as well share common credit strengths. These include access to significant EU funding over coming years via the Cohesion Policy and Next Generation EU programme, solid economic fundamentals, profitable banking systems, and robust institutions, helping the region cope with the energy crisis and supporting their respective credit ratings.

In addition, Estonia, Latvia and Lithuania benefit from comparatively low public debt ratios. Relatively robust growth in nominal terms should help stabilise debt-to-GDP despite widening budget deficits and rising financing costs within the euro area.

Scope Ratings’ next sovereign calendar review dates of the region are:

• Lithuania: 18 November 2022
• Estonia: 25 November 2022
• Latvia: 2 December 2022

For a look at all of today’s economic events, check out our economic calendar.

Giulia Branz is a Senior Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH.