Author: Anna Pluta

A report for BaltMet Invest. Baltic Sea Region INTERREG III B Project

Authors: Alf Vanags, Mark Chandler, Zane Leduskrasta, Sirje Padam.

This report is the result of an 18 month process in which the team followed a not always linear path. The particular challenge was how to incorporate the cross border element inherent in the idea of a coordinated investment strategy. In order to address this we have tried to move away form a model where the Baltic capitals are competing for investment and perhaps in the context of a growing shortage of workers competing also for people. This is line with the views of the EU Commission in its working paper on cohesion policy and cities (EC (2005)) where it is argued that competition can be counterproductive and the Commission’s working paper emphasises ‘coordination or strategic alliances’ as a ‘tool for balanced development’. The cooperative approach to a regional strategy is also evident at the political level in the recently published report on Europe’s Strategy for the Baltic Sea Region from the Baltic Strategy Working Group of 7 MEPs who have called for greater economic integration in the region including with Kaliningrad. Kaliningrad could indeed represent an opportunity to extend the methodology developed in the BaltMet Invest coordinated investment strategy. Here interestingly, the most recent evidence shows that the three Baltic metropolises are becoming increasingly integrated in terms of both trade flows and a common network of foreign direct investment (FDI).

The staring point of the report is the strategic and economic importance of the three Baltic capitals, Riga, Tallinn and Vilnius, in their countries and in the region. This is developed in the section on the economic role of the capitals. This importance is consistent with the EU policy context. In its working paper on cohesion policy and cities (EC (2005)) the European Commission underlines the importance of cities as key players in regional development, including cities located in peripheral areas. This is rather important for the Baltic capitals who, while peripheral in global and even EU terms, are arguably better located on the southern shore of the Baltic Sea than are Stockholm and Helsinki.

After analysing the economic role of the capitals the report examines evidence on what it is that investors look for. This followed by a discussion of the relative importance of competition and cooperation. A key element of the report is to turn the individual city visions into a common vision of “The Baltic region as the most attractive investment area in CEE” and the actions the city councils can take in promoting this.

This report examines the inflation experience of the EU new member states (NMS) since 2000, with particular focus on the three Baltic countries – Estonia, Latvia and Lithuania. Apart from being a natural focus of interest for residents of these countries it appears that their recent inflation experience – accelerating inflation in all three, with Latvia and Estonia posting the two highest NMS inflation rates in 2005 – marks them out from the other NMS. Indeed Latvia is the now the country with the highest inflation rate in all of the EU. At the same time the actual levels of inflation are different across the three Baltic countries. So the central questions addressed in the report concern the reasons behind the acceleration of inflation in the Baltic states when such an acceleration has not been observed in the other NMS and how to reconcile the ‘common Baltic acceleration’ with the observation that levels of inflation in the three countries remain different.

A key message of the report is that there is no mystery about the Baltic inflation experience in recent years – all is explainable in terms of fairly standard and well supported economic principles. This is true of both the inflation differential between the three Baltic countries and of the common acceleration. It is concluded that the inflation differential is largely explainable by the decision of the central banks of the three countries in the 1990s to peg their national currencies to different international units. Estonia pegged to the D-mark and then to the euro, Lithuania to the US dollar, and Latvia to the SDR basket of currencies. As a consequence the rather large movements in the euro/dollar exchange rate observed over 1999-2005 had very different price impacts in the three countries. As for the common inflation acceleration, developments in all the key economic indicators – growth, unemployment, credit, and wages – all point in the direction of economies that are seriously overheated.

Our detailed examination of inflation experience across countries points to a diversity of experience but a diversity that is also largely explainable in terms of economic analysis. Thus where underlying economic developments (eg growth) have implied the need for an adjustment in the real exchange rate vis-à-vis the euro this has been effected more by nominal exchange rate changes in countries where there has been a floating rate (Poland or the Czech Republic) and by changes in the domestic price level where the exchange rate has been pegged (the Baltic countries).

For Baltic governments who are pondering policy actions to reduce inflation the message is clear – if there is a serious intention to reduce inflation, then domestic demand needs to be reduced and if monetary policy is not available because of the constraint of pegged exchange rates then fiscal instruments must be used ie higher taxes or public lower expenditure or both. It will be painful – growth will decline, unemployment will rise and perhaps the property boom will collapse – but it will work.

Project No RRC IV – 086

Project report by Alf Vanags and Morten Hansen

This research is supported by a grant from the CERGE-EI Foundation under a programme of the Global Development Network. Additional funds for grantees in the Balkan countries have been provided by the Austrian government through WIIW, Vienna. All opinions expressed are those of the authors and have not been endorsed by CERGE-EI, WIIW or GDN.