A highly educated, skilled, and low-cost labor force in the heart of Northern Europe; working parliamentary democracies; favorable economic conditions; rapid economic growth; imminent entry into the European Union; a favorable tax and regulatory environment for investors: These are just some of the reasons why investing in the Baltic states of Estonia, Latvia, and Lithuania is so compelling today.
In 1997 the Baltic economies grew very rapidly. The GDP at constant prices rose 5.7 percent in Lithuania, 6.5 in Latvia, and 11.4 in Estonia, while inflation rates dropped from a high of over 110 percent, in 1993 to lows between 7 and 12.5. These trends are projected to continue.
Since regaining their independence in 1991 after 50 years of Soviet rule, the Baltic states are also regaining their role as a trade and transit bridge between East and West, and they may well become the Hong Kong of Russia. The recent Russian financial crisis will have only a minor effect on their GDP, mainly thanks to loosened trade and financial links the past few years. For example, Baltic trade with Russia has decreased to around 14 percent for Latvia and 21 percent for Lithuania, with the industries most effected being food, textiles, and pharmaceuticals. In the financial sector banks’ operating profits this year will be lower due to their exposure to Russian treasury bills and trade financing, but credit-rating agencies are not expected to change their opinions of the Baltics.
The nearby Nordic countries’ need to export production to areas with low-cost but skilled labor has created many opportunities in the Baltics. And several cities have recently established free-trade or economic zones, including Klaipeda and Siauliai in Lithuania and the Latvian ports Liepaja and Riga.
The Baltic states have meanwhile rebuilt their democratic institutions and reached national consensus on pro-growth and market-economy policies. They have tight monetary policies; government budget surpluses in Latvia and Estonia and a minor deficit in Lithuania; stable convertible currencies pegged to the western currencies; low foreign debt/GDP ratios; and free flow of capital. Furthermore, the governments have passed laws allowing foreigners to purchase companies out-right and land with few restrictions.
As the Baltics prepare to enter the European Union in four to seven years (Estonia is a first-tier applicant) and join the WTO, they are implementing the necessary legislation and standards, including a free flow of goods and services among themselves. Joining the European Union will give Baltic companies a competitive export advantage, but some companies that don’t meet the quality standards will probably perish. However, the trade and transit business will increase rapidly, and EU membership will most likely reinforce political and economic stability, leading to an increased flow of funds and appreciated assets for early investors. But international investors have already recognized the Baltics as serious candidates, as direct foreign equity investment in 1997 totaled almost $1 billion: $250 million in Estonia, $395 million in Latvia, and $340 million in Lithuania.
What drawbacks and risks are associated with investing in the Baltics? On the political side there is the unlikely possibility of direct Russian intervention. Russian residents in the Baltics creating instability would be likelier. And while the legal framework in these countries has evolved significantly in just a few years, it is not yet as sophisticated as in developed countries. Finally, due to rapid economic growth but a lack of policy focus, growing differences in income and wealth among nationalities, classes, central cities, and regions may lead to popular dissatisfaction and political shifts. With dissatisfied populations, the Baltics would be vulnerable to foreign intrigue and populism, with the flight of domestic and foreign capital a likely consequence.
On the economic front a very serious problem is growing trade deficits, which may lead to currency devaluation and the flight of capital. As of June 1998, the trade deficit as a percentage of GDP was over 19 percent for Lithuania, 20 for Latvia, and more than 31 for Estonia. However, due to the inward flow of foreign capital, their account balances as percentages of GDP were markedly lower: 11.7, 5.9, and 10.7 percent, respectively. International investors should therefore consider currency risk, even though the currencies are pegged and linkage with the euro is planned for 2000.
With those caveats in mind, investors should consider that certain sectors and industries are beginning to take on a more pan-Baltic shape and offer substantial growth potential. I recommend wood processing (more than half of Estonia and Latvia is forested), financial services, transit (trade, transport, and storage), tourism (including hotels), real estate, construction, apparel and textiles, food processing, certain consumer and light industries, and the soon-to-be or recently privatized utilities (including telecom). The opportunities are there for direct investors and fund managers, both directly and through the growing Baltic stock markets.
Having been in the Baltics for seven years and monitored their economies ever since, researching projects and making investments, I believe they are in the midst of a long-term boom with potentially profitable investment opportunities. The rewards of rapid growth clearly outweigh the risks of transition, so I place my bet with the Baltic people.
Hamid Ladjevardi, spent 12 years with Morgan Stanley, as an asset manager before launching Baltic Fund 1, a private equity fund registered in the United States and mandated to invest exclusively in Estonia, Latvia and Lithuania.