Publication: Monitor Volume: 6 Issue: 85

Russia’s 1998 financial crisis caused foreign trade to plummet in all three Baltic states. The loss of the Russian market hurt exports, but the sharp declines in domestic spending engineered by the Estonian and Latvian governments meant that imports declined even more sharply in both countries. This led to a substantial decline of their trade deficits. In Estonia, the current account deficit fell along with the trade deficit, from US$508 million in 1998 to US$297 million last year, or just 5.9 percent of GDP.

In Latvia, however, the current account deficit fell by only US$8 million last year, to US$636 million [10.2 percent of estimated GDP] (Bloomberg, March 30). While Estonia’s surplus on services last year offset two-thirds of the trade deficit, in Latvia the merchandise trade deficit accounted for a much larger portion of the current account deficit. Growth in Latvia’s current account deficit over the course of 1999 also provides cause for concern. As a share of GDP, the deficit rose from 6.9 percent in the first quarter to 8.1 percent in the second, 9.5 percent in the third, and 15.4 percent in the fourth.

As the Latvian economy and domestic spending recover from the effects of the Russian financial crisis, imports could easily grow faster than exports. This is in part because the commodity composition of Latvian exports–which contain a high portion of primary and low value-added goods–limits prospects for rapid export growth. Wood and wood articles are Latvia’s largest export item, accounting for 37 percent of total exports in 1999. Textiles make up another 15 percent, and base metals 12 percent (Monthly Bulletin of Latvian Statistics). Unless fiscal policy is tightened substantially, pressure on imports will remain high to satisfy both consumption and growing investment needs. Latvian enterprises are already boosting imports of capital goods, in order to make themselves more competitive on Western markets. By contrast, while Estonia also exports large amounts of wood articles (as well as textiles, live animals and food), machinery and appliances–higher value-added commodities–account for 21 percent of Estonian exports.

The relatively unfavorable composition of Latvia’s export basket increases the importance of foreign direct investment (FDI) as a source of financing Latvia’s current account deficit. Estonia’s current account deficit in 1999 was completely financed by FDI. In Latvia, however, FDI in 1999 only financed 38 percent of the current account deficit. If Latvian policymakers want to finance higher levels of consumption and domestic spending, they will need to make the country more attractive to foreign investors. Seen in this context, the mid-April collapse of the Skele government–over the pace of privatization–seems particularly disturbing.