Journal Issue

Baltic Cluster Report: Selected Issues

International Monetary Fund. European Dept.
Published Date:
May 2014
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The Baltic Model, Baltic-Nordic Links, and Convergence1

A. Introduction

1. The Baltic countries form a distinct group within a tightly integrated Nordic-Baltic region. However, they differ from the Nordics because of the challenges they faced upon regaining independence, with large differences in income, institutions, infrastructure, and other physical capital, notwithstanding the strong historical links with Nordics.

2. The Baltic countries also stand apart from their transition peers. Both groups came under central planning in the Soviet era. However, countries such as Poland, the Czech Republic, Hungary or Slovakia had a greater degree of autonomy and more institutional continuity before 1991. Because the Baltics reestablished independence much more abruptly, they entered the transition with the advantage of being able to create new institutions from scratch but also with the disadvantages of a more disruptive start to transition.

3. This chapter describes what sets the Baltics apart from others, while also drawing on links and similarities with other countries. The story has three parts:

  • The Baltic Model: In contrast to the “Nordic Model”, the “Baltic Model” described below is a set of revealed preferences rather than an articulated economic policy model. It is set out by comparing the Baltics to each other, peer countries, and selected higher-income countries.

  • Baltic links to the Nordics: While the Baltics are generally integrated with the rest of Europe, they developed a special link to the Nordics through proximity, shared history, and strong and increasing economic ties. Links are particularly strong in the financial sector, but also in FDI and trade.

  • Convergence: The Baltics are converging with advanced economies at a rapid pace in spite of the recent crisis. However, they face challenges of high unemployment, the structure of trade, and the ability of the financial sector to provide financing for growth. These topics are touched on here, but considered in depth in the other chapters of this Selected Issues Paper.

B. The Baltic Model

4. The Baltic countries are following similar approaches to economic policy, broadly in line with those of Northern European and the Anglo-Saxon countries. They are closer to the Anglo-Saxons than the Nordics in the structure of their public sectors, but they have a revealed preference for conservative and business-friendly fiscal policies, much in line with both the Anglo-Saxon and Nordic countries.2

The Macroeconomic Model

5. Their macroeconomic policies are generally robust (Figure 1).

Figure 1.The Baltic Macroeconomic Model

Sources: Eurostat; OECD; World Bank Doing Business; IMF GFS; WEO; and IMF staff calculations.

1/ Hungary data start in 2005.

2/ Chile data start in 2005, and Turkey data start in 2002.

3/ 1994-95 data for Baltics and Hungary.

4/ Without Canada.

5/ Without Mexico/Turkey: 2008-11.

6/ Without Slovenia/Switzerland: 2002-10.

7/ Data for Austria from 2011; for Israel, Korea, Canada, New Zealand, United States, Chile, Mexico and Turkey from 2010.

  • Inflation. The Baltic countries pursued exchange-rate based stabilization strategies in the 1990s which brought inflation down rapidly. However, the pegs in combination with positive confidence effects from European Union (EU) membership and improved credit ratings seem to have encouraged capital inflows that allowed overheating and a spike in inflation in the run-up to the global crisis.

  • Prudent public finances. These were kept in check more than in the CE4 peers, and public debt was low before the crisis.

  • Low public spending. The Baltics have small governments, particularly with respect to transfer payments. Expenditure is lower than in CE4 peers or the Nordics, and the share of GDP devoted to social benefits is substantially lower. On both the overall size of government and social benefits, the Baltics are closer to the Anglo-Saxons than the Nordics.

  • High labor taxation; low profit taxation. Profit tax ratios (as a percent of corporate pretax earnings) are less than half of the averages for the Nordics or the Anglo-Saxons. CE4 countries have similar labor tax rates (as a percent of corporate pretax earnings), but somewhat higher rates of profit taxation. Data on tax wedges on low income earners and on implicit taxation of labor and capital also point to relatively high incidence of labor taxes, especially when compared to the importance of profit taxation in the Baltics.

  • Moderately high income inequality. The Baltics’ tax and expenditure policy mix entails less redistribution than in the Nordics. Gini coefficients are higher in the Baltics than in the Nordics although similar to the Anglo-Saxons and lower than those of the emerging OECD economies, such as Chile and Mexico.

Average Annual Inflation

(Percent change)

Source: IMF WEO.

Implicit Tax Rates


Source: Eurostat.

The Structural Model

6. The Baltics are very open economies, with favorable investment climates (Figure 2).

Figure 2.The Baltic Structural Model

Sources: Chinn, Menzie D and Hiro Ito (2008). “A New Measure of Financial Openess”; WDI; UNCTAD; World Bank Doing Business; Transparency International ; and IMF staff calculations.

  • Their bank-dominated financial sectors are among the most open, and they have high levels of FDI and trade in their economies.3

  • The business environments of all three countries are ranked near the top. The World Bank’s Doing Business indicators put them behind only the very-high-ranked Nordics, Anglo-Saxons, and Korea, and ahead of some other advanced economies. However, perceptions of corruption are not as favorable.

  • They have also achieved high levels of labor force participation (particularly for women) and feature generally flexible labor market institutions.

  • They have also achieved high levels of human development.

Exports and Imports of Goods and Services, 2005-2012

(in percent GDP)

Sources: IMF BPTS; and IMF staff calculations.

Structure of Labor Market


Source: World Economic Forum.

Human Development Index, 2012

C. Baltic Links to the Nordics

7. The Baltic countries have strong ties to the Nordic states and other countries bordering on the Baltic Sea stretching back to the Middle Ages. Danish and Swedish rule in medieval and early modern times in Estonia and Latvia, trade links to all three Baltic countries through the Hanseatic League, and other influences tied the Baltic countries to the Nordic powers as well as Germany, Poland, and England. Lithuania was also strongly tied to Poland through the Polish-Lithuanian Commonwealth.4

8. A new period of integration between the Nordic and Baltic countries began after the Baltic countries re-established independence in 1991. The Baltic countries began establishing common institutions among themselves even before the break-up of the former Soviet Union, including the creation of a Baltic Assembly (analogous to the Nordic Council) in 1990. Cooperation between Nordic and Baltic institutions also developed quickly, including the umbrella NB8 framework incorporating all eight Nordic and Baltic countries, full membership in the Nordic Development Bank by the Baltic countries from 2005, and joint representation in international organizations such as the IMF and World Bank. The integration of the Nordic and Baltic countries at the official level is also paralleled by private economic ties. Membership in the EU also accelerated the process of integration and convergence.

Current Economic Ties

9. There are now strong economic links between the Nordic and Baltic countries, including in the financial sector, trade, and FDI (Figure 3). The Baltic countries all have financial sectors dominated by Nordic-headquartered banking groups. Nordic countries are also large direct investors in the Baltic countries, particularly in the case of Estonia, where Nordic investors account for more than half of total FDI. Trade links are also strong, although the shares are lower than for banking and FDI.

Figure 3.Economic Ties of the Baltics

10. These strong links are not just the result of proximity. While the financial sector links are obviously very strong, it could be argued that the investment and especially the trade links could be explained simply by proximity and the larger sizes of the Nordic economies. However, gravity model analysis that controls for the size of the partner country, the size of its economy, and geographic distance shows that the additional effect of being part of the Nordic-Baltic group is statistically significant for trade and inward FDI to the Baltics, and these results are robust over different time periods (Box 1).

Box 1.Nordic-Baltic Trade and Investment Linkages

We test the strength of regional integration in the Nordic Baltic region by estimating a standard gravity model. The standard gravity model relates cross border flows to population, economic size and geographical distance. In its basic form, the gravity model assumes that trade between two countries increases with their economic size and decreases with the distance between them. It is also common to add population as an additional variable related to market size. In addition, per capita income is often employed because it could reasonably proxy per capita expenditure and the propensity for imports (Paas and Tafenau, 2005).1 We expand this model to test whether relations are more intense within the Nordic-Baltic region, after controlling for the standard elements of a gravity equation. We do so by introducing a dummy that identifies the country pairs where both members are either a Nordic or Baltic economy. A significant coefficient on the dummy suggests that Nordic-Baltic regional links are stronger than can be explained by the standard gravity variables.

We estimate a gravity model for both bilateral trade flows as well as inward FDI positions. In particular, we follow (Paas and Tafenau, 2005) and test whether the dummy that takes the value 1 when the country pair belongs to the Nordic-Baltic group of countries is significant.2 For the trade regressions, we use bilateral real imports as their coverage is generally better than that of exports. For the FDI regressions, we use bilateral nominal stock exposures, controlling for the downward bias of the very small size of FDI from the Baltics into the Nordic economies. The model estimated is represented as follows:

where T denotes bilateral imports (or, alternatively, inward FDI positions), GDPpc real GDP per capita (or nominal GDP for the FDI regressions), POP populations, dist distance between capitals and I(NB) is the Nordic Baltic dummy. All variables are in log form. Because the distance between countries does not vary within the panel unit, we use the between estimator for our baseline model. However we also allow for country pair (random) effects in an alternative estimation.

Our analysis indicates that trade and FDI links within the Nordic-Baltic region go beyond those explained by standard gravity factors. In particular, econometric estimates do not reject the hypothesis that the particular strength of linkages between the Baltic and Nordic economies is an additional explanation for the size of regional cross border trade and investment flows. The Nordic Baltic dummy is significant and robust across specifications, in particular in the case of bilateral trade regressions.

Dependant variable: Real bilateral trade (imports)
Fixed effects, between estimatorRandom effects
Real GDP per capita_country0.
Real GDP per capita_partner0.
Distance between capitals−1.50.00−1.50.00−1.30.00−1.20.00
D (Nordic-Baltic)
D (shared border)0.10.680.50.01
Adjusted R20.820.820.810.81
Dependant variable: inward FDI stocks (nominal) 1/
Fixed effects, between estimatorRandom effects
Nominal GDP per capita_country1.
Nominal GDP per capita_partner2.
Distance between capitals−1.30.00−1.10.00−1.40.00−1.30.00
D (Nordic-Baltic)
D (shared border)
Adjusted R20.620.620.610.61

Nordics excluded as recipient countries as they receive little FDI from Baltics and would bias the results

Nordics excluded as recipient countries as they receive little FDI from Baltics and would bias the results

1/ Paas, T., and Tafenau, E., 2005, “European Trade Integration in the Baltic Sea Region—a Gravity Model Based Analysis”, Hamburg Institute of International Economics Discussion Paper #331.2/ Data are taken from various sources: UNCOMTRADE, CEPII and IMF CDIS, and WEO; the coverage includes EU27 and selected CIS countries and a time span of 2000-12 (trade data) and 2009-12 (FDI data).

11. Cluster analysis from the IMF’s Strategy and Policy Review Department visually summarizes trade, FDI, portfolio investment, and banking links.5 This analysis shows that the Baltic countries form a cluster with each other, Sweden, and Finland. Denmark and Norway are also closely tied to the Baltics through their common Nordic links.

D. Convergence

12. The Baltic countries have made a strong start on convergence in income toward the higher-income, more market-oriented economies. Whether because of the Baltic Model, the links to the Nordics, membership in the EU, or other factors, they have made substantial progress in reducing the gap over the last two decades. In this, they are a counter-example to the “stuck in transition” phenomenon explored in the recent European Bank for Reconstruction and Development (EBRD) Transition Report.6 Starting from income levels around ten percent of the Nordic or Anglo-Saxon countries in 1995, and about half those of the CE4 and the emerging OECD economies, they have tripled their income levels as a share of Nordic and Anglo-Saxon per capita GDP. Moreover, they have closed the gap and even surpassed the income levels of the CE4 and emerging OECD economies; notwithstanding the generally good performance of these peer groups.

13. Korea provides a more attainable reference point for Baltic income growth. The Baltic countries are still well below the Nordic or Anglo-Saxon countries in per capita GDP, but much closer to Korea (Figure 4). Their growth path over the last decade or so is quite similar to that of Korea roughly a decade earlier.

Figure 4.Convergence of the Baltics

E. Common Challenges

14. Notwithstanding their success thus far, the Baltics face some common challenges.

These are explored in detail in the subsequent chapters of this paper.

15. The financial systems are stable and well-capitalized, but they aren’t yet providing credit to support the ongoing recovery. Credit is still declining on average in spite of the recovery, except in Estonia. Reviving credit will be necessary to sustain growth and in the longer term, convergence. The relative importance of demand and supply factors in these creditless recoveries, policy responses, and the possible role of non-bank financing are considered in Chapter II of this Selected Issues Paper.

Baltics: Real GDP and Credit Growth

(year-on-year percent change)

Sources: Haver: and IFS.

16. Export growth may be difficult to maintain. Export-to-GDP ratios have grown rapidly in Latvia and Lithuania and have remained very high in Estonia. However, the structure of exports is not well-oriented toward fast growing countries or products. This calls into question whether they are well positioned to continue their good export performance. This will be explored in greater detail in Chapter III.

Share of Exports

(Percent of GDP)

Sources: WEO; and DOTS.

17. Unemployment has remained high even though the labor force has been declining (Figure 5). Population fell on average by over 10 percent in the Baltics in the last decade and by close to 14 percent in Lithuania and Latvia. Both low fertility rates, relatively low life expectancy (especially for males) and high rates of net emigration are contributing to this, and old age dependency ratios are high and rising. In spite of this, estimated structural unemployment remains high. The explanations for the apparently high rates of structural unemployment do not seem to be legal or contractual impediments to labor market flexibility. Instead, they may be partly the result of high taxation of labor income and skills and education mismatches. These issues are considered in Chapter IV.

Figure 5.Social Indicators in the Baltics

1/ Data for Turkey starts in 2005 Q1, data for Chile ends in 2009 Q4.

F. Conclusions

18. There is a “Baltic Model” and it has worked so far. The Baltics are charting a course of economic convergence with higher-income advanced economies—with clear commonalities among the three countries and differences from their transition and non-transition peer countries. While they are more closely linked to the Nordics, their policies are more laissez-faire and resemble those of the Anglo-Saxons in some ways. Their particular policy mix has been successful thus far with impressive income growth.

19. The revealed preferences of the Baltics resemble a mix of Nordic and Anglo-Saxon policies.

  • This model is a market-friendly and fiscally conservative approach similar to that of the Nordics and Anglo-Saxons.

  • The Baltics are closer to the Anglo-Saxons than the Nordic in terms of size of government and social benefits.

  • The business environment is close to that of the Nordics and Anglo-Saxons and comparable to or higher-ranked than that of other advanced economies and transition and non-transition peer countries.

  • However, high labor taxes are not a feature of Nordic or Anglo-Saxon policies, and this may be contributing to high structural unemployment rates, an area in which they stand apart from the Nordics and the Anglo-Saxons.

20. The Baltics are closely linked to the Nordics in many ways. Trade, investment, and financial links among the Nordic and Baltic countries are close, particularly for banking and particularly for Estonia across the range of economic links. The Nordic and Baltic countries are tending toward increasingly close linkages, particularly in banking. These linkages reinforce the need for policy coordination and collaboration that is already a feature of Nordic-Baltic cooperation.

21. The Baltics are converging rapidly toward their higher-income comparators. The

Baltic Model has produced high growth even compared to their very successful transition and non-transition economic peers. However, new challenges in increasing exports, providing adequate finance for economic growth, and reducing unemployment need to be addressed to sustain growth and convergence going forward.

Annex I. Comparators Groups
NordicsCE4 (transition peers)
DenmarkCzech Republic
NorwaySlovak Republic
Other Advanced OECD
Anglo-Saxons (majority-Anglophone advanced economies)Austria
New ZealandItaly
United KingdomJapan
United StatesLuxembourg
Emerging OECD
South KoreaMexico

Prepared by Greetje Everaert and Eugen Tereanu under the guidance of Tom Dorsey. Felix Winnekens provided excellent research assistance, and Solange de Moraes Rego and Fernando Morán Arce provided outstanding support.

The Nordics comprise Denmark, Finland, Iceland, Norway, and Sweden. The “Anglo-Saxons” are the majority-Anglophone OECD economies: Australia, Canada, Ireland, New Zealand, the United Kingdom, and the United States. The CE4 are the Czech Republic, Hungary, Poland, and the Slovak Republic. These and other comparator groups used in this paper are set out in Annex I.

Chinn, M. and Ito, H “A New Measure of Financial Openness”, Journal of Comparative Policy Analysis, Volume 10, Issue 3 September 2008, p. 309-322.

A recent general history of the Baltic countries is Andres Kasekamp’s A History of the Baltic States, (2010, London, Palgrave Macmillan).

The cluster analysis is described in IMF, 2012, “Enhancing Surveillance—Interconnectedness and Clusters” The analysis of cluster linkages for the Baltics was provided by Sophia Zhang and Franziska Ohnsorge.

European Bank for Reconstruction and Development, 2013 “Transition Report 2013: Stuck in Transition?” London.

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