Fading Baltic miracle: a dangerous dependence on the property bubble.

• Author: Hudson, Michael

The Baltics and other post-Soviet economies are financing deepening trade deficits--topped by Latvia's at 26 percent of GDP--by foreign borrowing. But unlike the typical case, it is not governments that are doing the borrowing. The booming real estate market is performing this role. Scandinavian and other foreign banks are extending mortgage credit to Latvians, Estonians, and Lithuanians, mostly denominated in euros, Swiss francs, dollars, and sterling. This breaks the cardinal financial rule that many Latin American and other economies discovered long ago: not to borrow in a hard currency when one's income is in a softer one.

Many Baltic debtors assume that just because their governments have announced their intention to join the euro, it is a sure thing--at today's exchange rates. Yet failure to meet the entry condition of a low inflation rate already has caused the target dates to be delayed indefinitely, and Latvia's currency began to wobble in early 2007.

But now that the Baltic real estate bubbles are peaking (led by that of Estonia), how are the Baltic states to finance their trade deficits? As the Baltic property market slows, foreign-currency loans are following suit.

First, some background. Soviet planning dispersed the various stages of each major industrial sector widely from the Baltics to Central Asia. From an engineering vantage point, the idea was to gain productivity advantages by creating specialization of labor. The Baltics, for instance, along with East Germany, were the Soviet Union's major computer and high-tech centers. The geopolitical effect was to lock the Soviet republics into a mutual interdependency so that none had a full complement of production facilities. This meant that when the Soviet Union broke up in 1991, its republics were not self-reliant.

Without self-sufficiency in consumer or capital goods, the post-Soviet countries face deepening structural trade deficits. Even as the World Bank applauds them for joining the ranks of the world's most "business-friendly" economies, their post-Soviet policy decisions may doom them to serve as an object lesson for the late economist Herbert Stein's maxim that "a trend that can't go on forever, won't." Their economic problem is how to balance their trade deficit without running even more deeply into debt and thereby building carrying charges into their balance of payments. And if the Latvian and Estonian currencies should decline against the euro, the squeeze will threaten to make their mortgage loans subprime.

The question is, what do they have to exchange? Russia and Central Asia have fuel and other raw materials, but the main endowment of Latvia and Estonia is favorable location--railway and port facilities for transshipping Russian exports to the West, and banking services that grew out of this trade by facilitating capital flight from Russia beginning in the late 1980s. Shaped by geography, about a third of the economic activity of Latvia (population 2.3 million) and Estonia (population 1.3 million) involves the trans-shipment of Russian oil and other raw materials. The U.S. Treasury has long placed Latvia on its list of shady banking countries, but finance remains the leading service sector, dominated by Scandinavian banks. Their profits derive mainly from mortgage lending, but they now are moving into auto loans and other consumer debt.

The Baltics import most of their consumer goods, capital equipment, fuels, and raw materials, and finance most construction equipment, cars, and consumer durables on credit. The balance-of-payments task confronting their economies is how to replace their former exports to the Soviet Union with new products and services to Europe and other regions.

Tourism is thriving. The proximity to Russia and Finland makes the Baltics natural meeting grounds for business conferences. (Lithuania does not share a border with Russia; its major links are with Poland and Belarus.) The hotel business is receiving major foreign investment, and Riga's seashore suburb of Jurmala has long been a summer mecca for affluent Russians.

Yet the residue of political anger left over from the half-century of Russian occupation is so deep that politicians in these countries seem to be shooting themselves in the foot by making relations with Russia as difficult as possible--the opposite of Chancellor Konrad Adenauer's policy in the 1950s of taking a pro Western political stance even while turning West Germany eastward...