Latvia: Russia would pose multiple problems for Latvia and its Baltic neighbors

From the beginning, it was clear that the economic crisis in Russia would pose multiple problems for Latvia and its Baltic neighbors. Until recently, many businesspeople in Latvia had seen close trade, transportation, and financial linkages as strengths that allowed their country to serve as Russia’s economic portal to the EU. Since the middle of last year, a collapse in oil prices, compounded by sanctions and countersanctions arising from the Ukraine conflict, have sent the Russian economy into a tailspin. Latvian ties to Russia have become liabilities rather than assets.

As the following chart shows, growth of the Latvian economy has slowed since the Ukraine conflict began in the spring of 2014, but not come to a halt. According to preliminary data for the first quarter of this year, growth remains equal to the Eurozone average, which itself is improving. In that regard, Latvia has done better than neighboring Estonia and Lithuania, which have also felt the impact of conditions in Russia.

A recent article from the Bank of Latvia helps explain why the damage has so far been limited. As the next chart shows, Latvia’s export markets are well diversified. Russia is the country’s second largest export partner, but even so, it accounts for only 11 percent of all outgoing goods and services. Furthermore, the bank reports, Russian countersanctions directly affect less than 5 percent of those exports, mainly food.

So far, falling demand, as the Russian economy has moved into recession, has caused more harm than policy actions by the Russian government, but potential geopolitical vulnerabilities remain. The Latvian transport sector is highly dependent on traffic to and from Russia, in part because of Russian-gauge rail lines built during Soviet times. Russia has threatened to divert some of that traffic to its own Baltic ports, although it has not yet done so. Also, Latvia remains dependent on Russian gas, although a new LNG terminal in neighboring Lithuania could provide a lifeline in case of a cutoff motivated by noncommercial considerations. Finally, Latvia has a large Russian-speaking minority. Some  observers worry that Russia could find elements among them to make trouble, especially in border regions. So far, however, there have been no sightings either of local separatists or of little green men in Russian uniforms without insignia.

What lies ahead? The next set of charts shows the evolution of growth forecasts from FocusEconomics. Analysts have revised their projections downward as the Russian crisis has deepened, but growth expectations for 2015 remain positive, and even the most pessimistic sources foresee a rebound of growth in 2016.

Moody’s Investor Services also remains bullish on Latvia. Earlier this year, it upgraded the country’s credit rating from Baa1 to A3. In doing so, it cited strong government finances, a result of successful fiscal consolidation during the 2008-2009 global crisis and recent success in strengthening tax collection. Moody’s also took note of reduced banking sector risk. Latvia’s banks hold large nonresident deposits, largely from Russia, but those have so far remained stable, and bank supervisors have taken measures to insulate the domestic banking sector from trouble in the event of any large deposit outflows.

In sum, Latvia remains an example of the ability of small economies to outperform larger ones in times of trouble. Writing on the website of the World Economic Forum a few years ago, David Skilling noted that

Successful small countries develop deliberate national strategies to engage with the world, build strong public sector capacity, and pursue inclusive growth models.  And the intense competitive realities small countries face mean that they are more likely to continuously adapt and innovate as the world changes—and less likely to run unsustainable policies.  Small countries behave with real seriousness of purpose.

This formula appears to characterize Latvia’s recent performance in the face of the economic turbulence created by low oil prices and the Russia-Ukraine conflict.