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Baltic Cluster Report: Selected Issues

Author(s):
International Monetary Fund. European Dept.
Published Date:
May 2014
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Exports and Global-Value-Chain Linkups: Experience and Prospects for the Baltic Economies1

A. Introduction

1. The external sectors of Estonia, Latvia, and Lithuania share important features and linkages. All three economies are typical small open economies with large exports relative to output, both in gross terms and in terms of the domestic value added of exports. They have become more open over time, gained market share, and reoriented trade away from the CIS. There are important similarities in the types of goods and services that they export and in what makes them attractive to foreign investors. The Baltic export sectors are further tied together by intra-Baltic trade, which has increased significantly over time, and strong trade linkages to the euro area and the Nordic countries have been longstanding characteristics of all three countries. They also all went through an extraordinary boom phase in the years preceding the global financial crisis which saw their current account deficits widen to unprecedented levels. A revival of exports on the back of wage restraint and productivity growth was instrumental in pulling out of the deep crisis and restoring external balance.

Trade Openness and External Demand Exposure

(Percent of GDP)

Sources: IMF, WEO; WIOT; and IMF staff calculations.

1/ Domestic Value Added.

2/ Foreign Value Added.

Current Account Balance, 2003-13

(Percent of GDP)

Source: IMF, WEO.

2. Thriving export sectors hold the key to future economic success of the Baltic economies and income convergence with Western Europe. Deep involvement in international trade is pivotal for the success of small economies, as they typically lack the market scale, input endowments, and comparative advantage in all the tasks involved in the production of sophisticated goods and services. Global value chains (GVCs), which allocate the stages of production of a good or service across many countries based on cost and competency considerations, have only further increased the role of the export sector in general, and the importance of being linked-up to GVCs in particular, although success can also derive from nimble niche market players or exporters that concentrate their production activities at home. The Baltic’s own recent economic history speaks loudly to the fallacy of income convergence primarily based on boosting domestic demand and the nontradable sector: convergence advanced quickly in the boom years only to suffer a huge setback in the crisis with the income gap to Western Europe now no smaller than six years ago. But trade openness inevitably also gives rise to spillovers as the economic wellbeing of trading partners—or rather all other GVC participants—has repercussions for economic activity at home.

3. This chapter explores the prospects for Baltic exports and what could be done to enhance them further.Section B reviews key features and developments of their export sectors, and confirms that they have been overall successful and a key pillar of the Baltic economies. Section C looks at FDI and involvement of the Baltic economies in GVCs and their role in export performance. On this front, the region has also faired fairly well but falls short of the achievements of the CE4 countries (Czech Republic, Hungary, Poland, and Slovakia), which are tightly linked into the German supply chain. Section D focuses on the main challenges that could arise. It finds that Baltic exports benefitted from tailwinds in the past, such as strong trading partner growth and favorable terms-of-trade developments. But more importantly, demographic aging and income convergence will likely make it an uphill battle to continue to thrive on labor-intensive exports. Section E concludes with perspectives on how these challenges could be addressed. It identifies a number of direct obstacles that stand in the way of trade and GVC linkup and explores scope for more regional cooperation and harmonization that hold the promise of efficiency gains and making the region more attractive to foreign investors.

B. Key Features and Developments of the Baltic Export Sectors

4. Pronounced gains in market share and rising export-to-GDP ratios are prima facie evidence of strong export performance. Since 2000, Latvian and Lithuanian exporters have increased their world markets shares by 100 and 150 percent, respectively, while Estonia, which had already secured a very strong position prior to 2000, managed a 70-percent increase. Market share gains were broad based for Latvian and Lithuanian exporters, but more confined to the Nordics and the United States in the case of Estonia. Market shares are lower when stripping out the import content of exports, i.e., focusing on domestic value-added exports rather than gross exports, as Baltic exports seem to embed more foreign inputs than those of the rest of the world, but the trend in market share gains is similar to the one for gross exports. Increases in the export-to-GDP ratio were also impressive. They came mainly after the 2008/09 crisis, after moving sideways in the preceding boom years.

Share of Exports in World Exports

(Percent)

Source: IMF, WEO.

Share of DVA of Exports in Global DVA of Exports

(Percent)

Sources: IMF, WEO; and WIOT.

Export to GDP Ratio

(Percent of GDP)

Source: IMF, WEO.

5. Some qualifications to this strong export performance are in order. The increase of export-to-GDP ratios is also due to favorable export price developments for all three countries and fast growth in the trading partners of Latvia and Lithuania. In addition, the very strong increase of export ratios in the post-crisis period seems to have been driven in part by a surge in re-exports—goods that enter and leave the country in the same state and therefore contribute to domestic activity only through related services exports, such as transport.2 Nonetheless, a sizable underlying improvement of the export-to-GDP ratio remains.3

Baltic Countries: Decomposition of the Export Performance(Percent of GDP)
2009-132003-082000-13
EstoniaLatviaLithuaniaEstoniaLatviaLithuaniaEstoniaLatviaLithuania
Exports, beginning period year63.943.954.269.242.250.984.641.944.5
Exports, end period year88.059.786.371.043.159.688.059.786.3
Exports, change24.115.732.11.90.98.73.417.741.8
Underlying export effort20.54.016.5−1.32.93.56.56.035.8
Global and other factors3.711.715.63.1−2.05.2−3.111.76.0
Globalization effect 1/5.84.04.910.56.47.711.95.96.2
Trading partner effect 2/1.12.50.34.51.71.39.97.94.2
Global price effect 3/−7.0−4.8−5.9−0.3−0.2−0.2−14.7−7.3−7.8
National price effect 4/5.89.616.7−7.1−4.22.8−4.78.29.4
National GDP growth effect 5/−1.20.50.4−3.2−4.8−5.7−2.5−1.8−4.0
Unallocated−0.8−0.1−0.8−1.3−0.9−0.7−2.9−1.1−2.1
Sources: IMF, World Economic Outlook; and IMF staff calculations.

Arising from global real exports growing faster (+) or slower (-) than global real GDP.

Arising from trading partner real imports growing faster(+) or slower (-) than real global exports.

Arising from global export prices growing fast (+) or slower (-) than the deflator of global GDP.

Arising from national export prices growing faster (+) or slower (-) relative to the national GDP deflator than global export prices relative to the deflator of global GDP. Also captures to some extent quality improvements in export goods and post-crisis “internal devaluation,” which could be viewed as part of the underling export effort. However, due to data limitation these cannot be separated out and reclassified.

Arising from national real GDP growing faster (-) or slower (+) than global real GDP.

Sources: IMF, World Economic Outlook; and IMF staff calculations.

Arising from global real exports growing faster (+) or slower (-) than global real GDP.

Arising from trading partner real imports growing faster(+) or slower (-) than real global exports.

Arising from global export prices growing fast (+) or slower (-) than the deflator of global GDP.

Arising from national export prices growing faster (+) or slower (-) relative to the national GDP deflator than global export prices relative to the deflator of global GDP. Also captures to some extent quality improvements in export goods and post-crisis “internal devaluation,” which could be viewed as part of the underling export effort. However, due to data limitation these cannot be separated out and reclassified.

Arising from national real GDP growing faster (-) or slower (+) than global real GDP.

6. Baltic exports seem competitively priced, consistent with market share gains and rising export ratios. The various approaches routinely employed by IMF staff to detect exchange rate misalignments confirm the absence of significant over or undervaluation in the exchange rates of Estonia, Latvia, and Lithuania at this time. Price competitiveness had been dented in the boom years as unit labor costs in the Baltic economies grew much faster than in western competitors, contributing to stagnation in export-to-GDP ratios and confining market share gains largely to terms-of-trade effects. Real exchange rate assessments based on purchasing power considerations also point to a degree of overvaluation in the boom years, although the bulk of the large current account deficits of the time reflected imports bloated by the domestic demand boom rather than exports hampered by overvaluation. In any event, a combination of wage restraint and productivity advances in the post-crisis period reduced Baltic unit labor costs by 10 to 20 percent relative to those of western European competitors. This boost to price competitiveness was promptly rewarded by a surge in exports.4

Decomposition of ULC Change 2008-12(Percent)
Relative to Western EuropeNominal ULC
Estonia
Change in ULC−10.5−1.5
Labor compensation−6.34.0
Labor productivity 1/−4.6−5.5
Latvia
Change in ULC−21.7−13.9
Labor compensation−10.3−0.5
Labor productivity 1/−14.6−15.6
Lithuania
Change in ULC−14.2−5.6
Labor compensation−3.57.0
Labor productivity 1/−12.4−13.4
CE4
Change in ULC−8.80.4
Labor compensation−6.24.1
Labor productivity 1/−2.8−3.7
CESEE
Change in ULC−5.24.3
Labor compensation−6.43.9
Labor productivity 1/1.20.4
Sources: Eurostat; and IMF staff calculations.

Negative sign indicates negative impact on ULCs and an improvement in labor productivity.

Sources: Eurostat; and IMF staff calculations.

Negative sign indicates negative impact on ULCs and an improvement in labor productivity.

Purchasing-Power-Parity Exchange Rates

Sources: WDI.; and IMF staff calculations.

7. Over the past two decades, Baltic exports reoriented successfully from the CIS toward CESEE and to intra-Baltic trade. The European Union as a whole has been the most important export destination from the mid-1990s, reaching a peak a decade later, and declining moderately since to 67 percent in Estonia, 61 percent in Latvia, and 55 percent in Lithuania. A more granular analysis shows a steady rise in the importance of trade among the Baltic economies (reaching a share of 15-27 percent) and with CESEE (reaching a share of 4-9 percent). The share of the CIS collapsed in the 1990s but made a partial comeback after the Russian crisis in 1999 and remains sizable, especially in Latvia and Lithuania. The Nordic countries are consistently important export destinations, above all for Estonia with a share of around 40 percent. The rest of the euro area absorbs between 17 and 28 percent of Baltic exports, with no clear trend over time.

Baltic Countries: Export by Destination, 1994-12

(Percent of total exports)

Sources: DOTS; and IMF staff calculations.

8. Services exports are a traditional strength of the Baltic economies but only Estonia has a strong presence in the high-end segments. In all three countries, external services accounts have always been in surplus, reflecting large exports of transportation services related to Russian trade going through Baltic ports. Overall, services exports account for a somewhat larger share in total trade than in CESEE or globally. However, sophisticated and particularly dynamic services exports, such as information and communication technology (ICT) or “other business services,” play an important role only in Estonia. At 7 percent of total exports their share is not far behind that of the Nordic countries or the euro area. In Latvia and Lithuania these shares are only half as large at best, though ahead of CESEE generally.

Composition of Exports

(Percent of total)

Sources: UNCTAC; DOTS; and IMF staff calculations.

9. The quality catch-up in the goods that the Baltic countries export seems to have plateaued. Judging by the prices that Baltic exports are managing to fetch in global markets, the quality of export goods appears to have improved strongly between the mid-1990s and the mid-2000s, consistent with outdated products inherited from the central-planning era being upgraded to western standards.5 Since then, the quality of Baltic exports have broadly evolved in line with global trends, but not improved faster than in global markets generally. With the bulk of the quality catch-up of the existing product mix already accomplished, the ability to fetch higher prices in global markets going forward will depend on the capacity of Baltic exporters to shift to new products and enhance non-price competitiveness. Benkovskis and Wörz (2013, 2014) underscore the importance of non-price factors and empirically show their dominant role for the BRICS countries in gaining world market share between 1996 and 2011.

Baltic Countries: Product Quality of Exports

(1995 - 2012)

Sources: WITS; and IMF staff calculations.

Baltic Countries: Revealed Comparative Advantage by Industry Groups(In terms of DVA exports, 2007-09 average)
EstoniaLatviaLithuania
Agriculture and mining0.300.390.31
Labor-intensive manufacturing2.581.891.73
Capital-intensive manufacturing1.070.721.09
Knowledge-intensive manufacturing0.560.300.37
Labor-intensive service2.175.073.99
Capital-intensive service1.512.242.82
Knowledge-intensive service1.070.540.26
Public service0.791.510.68
Sources: WIOT; and IMF staff calculations.
Sources: WIOT; and IMF staff calculations.

10. Evidence on how well the product structure positions the Baltic export sectors for future growth is mixed:

  • On the one hand, export growth has been concentrated in labor intensive goods and services rather than knowledge intensive sectors, which likely have better future potential. Baltic exports generally exhibit revealed comparative advantage in labor intensive goods and services and disadvantage in knowledge intensive activities, although Estonia has carved out a small advantage in knowledge intensive services in recent years.6 Major Baltic exports with high revealed comparative advantage are wood, food products, animals and vegetables, as well as fuels in the case of Lithuania, reflecting to a large extent the countries’ resource endowments. Classifying exports according to their technology intensity confirms that high and medium-to-high technology goods account for a relatively low share of Baltic exports compared to the CE4 countries, although in absolute terms the sophistication of Baltic exports has increased substantially since the turn of the century whether measured in terms of factor intensity, educational intensity, or technological intensity (Bank of Lithuania, 2013).

  • Summary indicators of export sophistication confirm progress but at a declining rate.Hausmann et al. (2005) propose the indicator of the “income level implicit in exports,” which essentially is a weighted average of the per-capita GDP of competitor countries in the relevant export product groups. For the Baltics, this measure shows a steep increase during 1997-2005; but a flattening thereafter. In an application to Latvia, Vitola and Davidsons (2008) find that “potential of almost all groups of currently produced goods to act as drivers of development has already been exhausted to a large extent” (p. 2).

  • One the other hand, a fair proportion of Baltic exports is concentrated in globally dynamic product categories and Baltic exporters managed to gain market share in most of them. During 2008-12, between 35 and 45 percent of Baltic exports comprised products the markets for which expanded relatively strongly at the global level.7 The pertinent dynamic product categories for the Baltic countries include food, chemicals, plastics and rubber, metals, and footwear—and have changed little from earlier periods. While Baltic exports are thus somewhat underexposed to globally dynamic product categories, they are still better positioned than exports from CE4 economies, where exports of dynamic products account for only 31 percent of total exports. Moreover, Baltic exporters managed to gain market share in most of the dynamic product categories they operated in during 2008-12, whereas less than a third of the CE4 exporters did so.

Income Level Implicit in Exports, 1997-2011

(PPP GDP per capita in 2005 US$)
Share of Exports by Its Type(Percent of total exports)
1998-20022003-072008-12
Estonia
Dynamic products47.529.940.5
Of which: with rising Estonian market share33.322.631.3
Non-dynamic products52.570.159.5
Latvia
Dynamic products34.034.733.8
Of which: with rising Latvian market share17.332.017.4
Non-dynamic products66.065.366.2
Lithuania
Dynamic products47.440.945.5
Of which: with rising Lithuanian market share40.236.333.9
Non-dynamic products52.659.154.5
CE4 countries
Dynamic products45.543.831.3
Of which: with rising CE4 market share37.341.79.1
Non-dynamic products54.556.268.7
Sources: UNCOMTRADE; and IMF staff calculations.
Sources: UNCOMTRADE; and IMF staff calculations.

C. FDI and Integration in Global Value Chains

11. FDI and GVC linkup can substantially strengthen the export sectors of catch-up countries and thereby spur income convergence. Inward FDI provides additional resources for investment to the recipient economy, facilitates the transfer of technology and knowhow, and spurs exports if directed at the tradable sector. Foreign firms in the Baltic countries appear more productive and export oriented than domestic firms, judging from the detailed information available for Estonia (Box 1). FDI is often closely related to GVCs, with companies from advanced economies that move part of their production processes abroad also investing abroad (UNCTAD, 2013). Compared to traditional FDI, GVCs offer the additional benefit of at least partially involving host countries in operations that would be too large and complex to run purely on a domestic basis and would otherwise likely not materialize at all—a particularly pertinent consideration for small economies not operating at the cutting edge of technological advancement. GVC participation tends to push up trade in intermediate goods and the content of imported inputs embedded in exports. While rising amounts of imported inputs eat into the value added of exports that is generated domestically, GVCs typically spur gross exports sufficiently to accommodate an increase of both foreign-generated and domestically-generated value added from exports (Rahman and Zhao, 2013). Outsourcing, also referred to as off-shoring, creates GVCs too, but through contracting some business tasks out to third-party providers abroad rather than engaging in FDI. Just as FDI, outsourcing gives rise to valuable transfer of knowhow to host countries, at least over time as less demanding tasks such as operating call centers evolve into mid-office functions, such as financial analysis or tax management (Cienski, 2013).

12. The Baltic countries managed to attract sizeable amounts of FDI, with Estonia particularly successful. At 80 percent of GDP, Estonia’s FDI stock was roughly twice as large as that of its Baltic neighbours. Latvia and Lithuania rank somewhat lower than most countries in the region in terms of the cumulative FDI up to 2012, but they are still above the global median. Swedish companies are the most important foreign direct investors in all three countries, followed by Finland in the case of Estonia, the Netherlands in the case of Latvia, and Poland in the case of Lithuania.

Foreign Direct Investment, 2012

(Percent of GDP)

Sources: IMF, Consolidated Direct Investment Survey; IMF, World Economic Outlook; and IMF staff calculations.

Box 1.Foreign Enterprises in Estonia

Foreign companies in Estonia are mainly involved in export-oriented activities, including manufacturing; transportation and storage, trade and motor vehicle repairs, information and communication, and professional, scientific, and technical activities. In 2011, they represented some 27 percent of employment in the tradable sector, and contributed about 18 percent of the country’s GDP and 40 percent of its exports.

  • Compared with its domestic counterpart, a foreign firm employing 20 workers or more is on average twice as big, more profitable, and has a higher export ratio. Also, it has higher labor compensation and higher labor productivity.

  • During 2008-11, foreign enterprises were responsible for half of Estonia’s exports and two-thirds of manufacturing exports. They played a key role in Estonia’s export-led economic recovery of 2010-11, when their exports grew by a cumulative 117 percent compared to a 37 percent expansion of exports by domestic firms.

  • During 2008-12, foreign enterprises accounted for about one third of private investment and over 40 percent of private investment in the manufacturing sector.

Estonia: Key Indicators Of Enterprises Employing More Than 20 Workers(Percent, unless otherwise indicated; 2011)
Foreign firmsDomestic firms
TotalO/w: Nordics
Average size (number of employees)11711865
Average compensation per employee (CE)15.414.913.1
VA per employee (1,000 euros)28.828.322.4
CE as a share of VA53.552.558.5
Net profit as ratio to VA27.528.025.4
Fixed investment as ratio to VA17.821.138.0
Export ratio65.967.538.6
Sources: Estonian authorities; and IMF staff calculations.
Sources: Estonian authorities; and IMF staff calculations.

13. The availability of skilled labor at affordable prices and a favourable business environment seem to be the key attractions of the Baltic economies. Domestic market growth potential and proximity to markets and consumers emerge as key attributes of emerging market economies in the comprehensive survey of foreign investors by fDi Markets, including for the Baltic economies. But the comparative advantage of the Baltic economies seems to lie in lower costs and skilled work-force availability, with these factors deemed much more important than for emerging market economies generally. Regulations or business climate are also key assets bringing foreign investors to the Baltic countries, consistent with the favorable readings of the “Doing Business” indicators complied by the World Bank, which rank Lithuania, Estonia, and Latvia 17th, 22nd, and 24th, respectively, out of 189 participating countries.

Baltic Countries: FDI Projects’ Most Frequent Motives and Determinants, 2003-13

(Percent)

Sources: fDi Markets, Financial Times; and IMF staff calculations.

14. The Baltic economies also achieved a fairly good linkup to GVCs, but only Estonia comes close to the degree of integration seen in the CE4 countries. According to the GVC participation index, Latvia and Lithuania are linked up as much as the global average, which increased steadily up until the global financial crisis.8 Notwithstanding Estonia’s substantially higher participation, all three Baltic economies are considerably less involved in GVCs than that the CE4, whose pivotal role in the German supply chain is well known and documented (IMF, 2013). Apart from large unit labor cost differentials and adequate labor skills to support supply chain activities, the CE4’s integration into the German supply chain reflects several bilateral advantages vis-à-vis Germany: geographical proximity, cultural similarities, and similar sectoral structure.

Global Value Chain Participation 1/

(Percent)

Sources: WIOT; and IMF staff calculations.

1/ Foreign value added of exports plus domestic value added of exports that are used as inputs for exports in country of primary destination. Both are expressed as shares of exports.

15. The Baltic GVCs may take a looser form than those in the CE4 or Asia. The GVC participation index makes no distinction between tighter and looser forms of GVCs: by measuring the amount of imported inputs embedded in exports and the amount of exports going to third countries, it makes no distinction between a tight relationship like the one between Volkswagen of Germany and Skoda of the Czech Republic and a looser one where a domestic exporter simply sources a lot of inputs abroad. Anecdotal evidence suggests that these tight forms of GVCs are generally rather rare in the Baltic countries, although a fair number of them seem to have developed between Estonia and Finland and Sweden and there should be no presumption that tight GVCs are necessarily more advantageous than loose ones. The share of intermediate industrial goods in trade is a useful supplementary indicator for GVC involvement that is less prone to capture loose GVC links. On this metric, all three Baltic countries show less involvement in global value chains than the world as a whole.

Share of Intermediate Goods in Total Trade

(Percent of total goods exports)

1/ Excluding CE4 countries (Czech Republic, Hungary, Slovak Republic, Poland).

Sources: UNCOMTRADE; and IMF staff calculations.

16. GVC involvement also means that the Baltic countries’ exposure to global economic developments is different than that suggested by gross export figures. Exposure to overseas developments is best gauged by the domestic value added of exports absorbed by the country of final destination. Imported inputs embedded in exports do not affect domestic economic activity; exports that are not consumed in the primary country of destination but embedded in further exports to third countries depend on economic developments in third countries. In the Baltic economies, exports in domestic value added terms account for between 45 and 60 percent of GDP, suggesting that a foreign demand shock of 1 percent would affect GDP to the tune of 0.45 to 0.6 percent on impact. In terms of the geographical composition of exposure, the importance of the Nordic countries, the euro area, CESEE, and intra-Baltic trade declines when focusing on the final destination of domestic-value added exports rather than the primary destination of gross exports. This suggests that these regions—particularly the Nordics—function to some extent as gateways for Baltic exports to the rest of the world.

Gross Exports by Primary Destination vs. DVA Exports by Final Destination, 2011

(Percent of total exports)

1/ Other includes: Australia, Brazil, Canada, India, Indonesia, Japan, Korea, Mexico and Taiwan.

Sources: WIOT; and IMF staff calculations.

17. The Baltic countries have been recipients of business outsourcing but its extent is hard to quantify. Unlike FDI, outsourcing is not tracked in official statistics. Tholon, the global outsourcing advisory firm, keeps tabs on the top outsourcing destination around the world. It currently only lists Tallinn among its top 100 destinations. Deloitte mentions Vilnius as a “hotspot” for shared services locations in Europe—because of high growth rates from a modest base. There are also numerous examples of Lithuania attracting technical support centers or regional operations centers of multinational companies, although these seem to be typically established by these companies themselves and would therefore already be captured in FDI statistics. According to Tholon, key factors for attracting outsourcing are skills and scalability of labor, overall costs, the business environment, infrastructure, and low risks to business.

D. Potential Challenges for the Baltic Export Sectors

18. Despite their past good performance, future success of the Baltic export sectors should not be taken for granted. Export volume growth has come down sharply from the double-digit rates achieved in the early years of the post-crisis recovery phase, to reach 2.3, 1.1, and 8 percent in 2013 for Estonia, Latvia, and Lithuania, respectively. While still a respectable performance in a year where global trade expanded only at timid rate of 2.7 percent, it may also indicate that the momentum from post-crisis adjustment and reform is petering out. The Baltic economies have also been less successful in attracting FDI in recent years—their share of global FDI declined from 0.38 percent during 2005-07 to 0.21 percent during 2010-12. In any event, continued success of the Baltic export sectors will hinge on their ability to adapt to a fast-changing global economy.

19. Several tailwinds that benefitted the Baltic export sectors in the past are likely to fade. Fast growing imports of trading partners facilitated the expansion of Baltic exports in the past. However, according to the latest WEO, trading partner import growth for all three Baltic economies is projected to decline substantially and fall below global trade growth—a sharp contrast with the past decade when it enjoyed a premium. Favorable price developments for Baltic exports are also likely to subside. No matter whether they reflected fortuitous movements of prices on global markets or the catch-up in the quality of Baltic exports to western standards that is now largely complete, a repeat cannot be expected.

Baltic Countries: Trading Partners’ Real Import Growth(Percent, annual average)
2003-132014-18
Estonia6.14.7
Latvia6.54.9
Lithuania6.04.5
Global exports5.65.3
Sources: DOTS; and IMF staff calculations.
Sources: DOTS; and IMF staff calculations.

20. Demographic aging is emerging as a new key challenge for Baltic export sectors, including their ability to attract FDI. Birth rates in all Baltic countries collapsed some 25 years ago in early transition—and have yet to recover decisively. This means that the cohorts that will be completing tertiary education from now on will be much smaller than in the past. The associated drain on labor supply is a particular challenge when the export sectors are specialized in the provision of labor intensive goods and services. It will also make it more difficult to attract foreign investors who have traditionally flocked to the Baltic region because of the availability of affordable and skilled labor. More generally, demographic aging tends to adversely affect FDI (Narciso, 2010).

Population Age 25-34, 2000-40

(2000 = 100)

Sources: UN Population Division; and IMF staff calculations.

21. The export product mix and the degree of GVC involvement raise questions about the ability to extend the Baltic export success. The Baltic export sectors have been specialized in labor intensive goods and services and have fared well. Nonetheless, rising sophistication of products and production, the critical importance of technology and knowledge, and intensifying competition from developing and emerging market economies suggest that maintaining strong performance with the existing export mix could well prove an uphill battle, even without the demographic challenges. Berg et al. (2008) show that export composition matters, as increasing export product sophistication tends to prolong growth episodes. Increasing sophistication at the global level will also make it more critical than ever to be tightly involved in GVCs—an area where at least the export sectors of Latvia and Lithuania have some way to go in catching up with the best performers in the region.

E. Securing Vibrant Export Sectors for the Future

22. Vibrant export sectors in the Baltics are vital for long-term economic stability and income convergence. Securing and expanding market share, moving up the value chain, attracting FDI and GVC linkup, and repositioning toward promising export products against the inevitable odds of demographic aging will require a multi-pronged approach. Generally speaking, the Baltic countries should seek to build on their existing strengths, including economic flexibility, qualified human capital, sound macroeconomic policies, and generally good economic governance. Policies will need to aim at maintaining competitiveness and strengthening resilience to shocks.

23. Maintaining price competitiveness and fostering productivity growth will be essential. The post-crisis experience clearly speaks to the powerful effects from lowering ULCs relative to competitors. These hard-won competitiveness gains should be protected by keeping wage developments in line with productivity growth. Wage formation should remain market determined with a role for government in setting public sector and minimum wages and providing analysis of labor market developments. The focus should clearly be on securing high productivity growth, including through the steps discussed below, with wages following suit as productivity gains materialize over time.

24. The Baltic economies generally fare well on business-environment indicators, but addressing areas of relative weaknesses is essential to remain attractive. The Baltic countries ranked among the best on the World Bank 2014 Doing Business indicators, outperforming most of their EU peers, and were among the 25 countries (out of 189) where doing business is deemed the easiest. The IMD World Competitiveness Report paints a less favorable picture as the region’s competitiveness is dragged down by limitations in the R&D culture (except for Estonia) and inefficiencies in the legal environment and public services. Perhaps most directly relevant for trade, FDI and GVC linkup are perceived impediments identified in the WEF’s Global Enabling Trade Report (2012). While all countries score above average overall, there are areas for improvement: shortcomings in services and infrastructure seem to stand in the way of transshipment connectivity, hiring of foreign labor appears to be difficult, and trade financing is reportedly not easy to come by.

Baltic Countries: Global Enabling Trade Index 2012(Country rank out of 132 countries)
EstoniaLatviaLithuania
Overall Index265245
1st pillar: Domestic and foreign market access676767
2nd pillar: Efficiency of customs administration114944
3rd pillar: Efficiency of import-export procedures82334
4th pillar: Transparency of border administration235241
5th pillar: Availability and quality of transport infrastructure504762
5.01 Airport density, number per million pop.108041
5.02 Transshipment connectivity, index 0-100 (best)899290
5.03 Paved roads, % of total87188
5.04 Quality of air transport infrastructure, 1-7 (best)7151101
5.05 Quality of railroad infrastructure, 1-7 (best)443725
5.06 Quality of roads, 1-7 (best)479431
5.07 Quality of port infrastructure, 1-7 (best)174841
6th pillar: Availability and quality of transport services547658
6.01 Liner Shipping Connectivity Index, 0-152.1 (best)889179
6.02 Ease and affordability of shipment, 1-5 (best)748456
6.03 Logistics competence, 1-5 (best)658957
6.04 Tracking and tracing ability, 1-5 (best)596482
6.05 Timeliness of shipments in reaching destination, 1-5 (best)769137
6.06 Postal services efficiency, 1-7 (best)256855
6.07 GATS commitments in the transport sector, index 0-1 (best)272521
7th pillar: Availability and use of ICTs153624
8th pillar: Regulatory environment306274
8.01 Property rights, 1-7 (best)276658
8.02 Ethics and corruption, 1-7 (best)306267
8.03 Undue influence, 1-7 (best)276266
8.04 Government efficiency, 1-7 (best)289072
8.05 Domestic competition, 1-7 (best)276285
8.06 Efficiency of the financial market, 1-7 (best)447085
8.07 Openness to foreign participation, index 1-7 (best)216177
Ease of hiring foreign labor, 1-7 (best)867096
Prevalence of foreign ownership, 1-7 (best)426383
Business impact of rules on FDI, 1-7 (best)1894106
Openness to multilateral trade rules, index 0-100 (best)154412
8.08 Availability of trade finance, 1-7 (best)6268100
9th pillar: Physical security195242
Source: WEF, The Global Enabling Trade Report 2012. Highlights added.
Source: WEF, The Global Enabling Trade Report 2012. Highlights added.

25. Domestic investment is a key ingredient for future export performance. It will help boost future productivity, secure continued capital stock accumulation and ensure its modernization, and facilitate the gradual shift to product categories that have high potential for the future. Private investment has not yet fully recovered from the crisis and remains below its long-term average. In this context, it remains essential to ensure that financing is not unduly held back by credit supply by banks and that other financing avenues are explored, as discussed in Chapter II. Securing sufficient fiscal space for public investment is equally important. Thanks to EU funds, which the Baltic countries are very successful at absorbing, public investment ratios are only marginally below their longer-term average. But it is less clear whether EU funds are efficiently deployed to help shift exports toward more promising goods and services.

26. Upgrading infrastructure and making the most of the available labor force are priorities for attracting FDI, facilitating GVC linkup, and strengthening the export sector generally.

  • It is difficult to change the demographics of the labor market in the short-run, but tackling high structural unemployment could materially augment the effective labor force. Despite being viewed by investors as having relatively skilled labor forces, skill and education mismatches still appear to be an issue in the Baltics. Chapter IV analyzes these issues and makes a number of recommendations for addressing skill mismatches and upgrading skill levels.9 Moreover, liberalization of emigration practices could help address shortages in selected labor market segments, thereby suitably supplementing the domestic labor force.

  • An efficient and integrated transportation infrastructure is key for trading across borders and can bring important benefits for countries that are geographically close to key markets. The Baltic transportation infrastructure is well attuned to trade in the east-west direction, but north-south passage ways are less well developed. Moreover, a smooth interface between different modes of transportation, supported by integrated services, is important.

  • Energy prices are an important cost factor for exports. The Baltic energy sectors remain highly dependent on Russia as their dominant supplier, which also limits the scope for unleashing the full forces of competition in the energy sector. Currently, the Baltic countries face among the highest energy costs in Europe (when adjusted for purchasing power), which weighs on investment and competitiveness. The authorities are rightly pushing ahead with building the infrastructure that will secure diversity in energy supplies to lower import prices and facilitate competition between energy providers.

27. Regional cooperation and harmonization could also improve the operating environment for Baltic exports. As small countries, the Baltic economies might lack the economies of scale that some of their larger competitors enjoy: foreign investors might not come because of insufficient market size or labor pools, lumpy infrastructure investment might be too large for any one of the Baltic countries to shoulder on its own, etc. While the argument that small countries face a disadvantage of scale should not be taken too far—there are a host of highly successful small states around the world, because being small also comes with the advantage of being able to be more flexible—cooperation and harmonization can ameliorate scale disadvantages where they truly exist. Infrastructure is yet again a prominent candidate, ranging from transportation and energy to financial markets, where investments are bulky and may not pay off if carried out by each country individually in an uncoordinated fashion. Harmonization of rules and practices across the Baltic countries would contribute to investors starting to perceive the region as a larger economically integrated entity where they can count on similar standards to apply. A joint FDI agency might help spread the message.

References

Prepared by Ramdane Abdoun, Bartek Augustyniak, M. Astou Diouf, Ruy Lama, Weicheng Lian, and Hongyan Zhao under the guidance of Christoph Klingen. Bartek Augustyniak provided excellent research assistance, and Solange de Moraes Rego and Fernando Morán Arce provided outstanding support.

Re-exports accounted for 30 percent of Lithuania’s exports in 2009 and are predominantly destined for Russia. In the subsequent three years they grew by 137 percent, whereas exports of Lithuanian origin grew at a slower rate of 77 percent (cumulatively and in nominal terms). In Estonia, re-exports account for 12 percent of total exports. Comparable data for Latvia are unavailable.

Exchange rate movements are likely to have flattered world market share gains. The euro has appreciated by about one-third against the US dollar since 2000, thereby boosting the valuation of trade with advanced Europe relative to global trade and thus the market share of countries that trade heavily with advanced Europe, such as the Baltic economies. Consistently, market shares calculated from real exports show only half the gain seen in market shares based on nominal exports.

For a broader discussion of the Baltic boom-bust-recovery experience see Bakker and Klingen (2012), or Hansson and Randveer (2013). Blanchard et al. (2013) offer a discussion of the case of Latvia.

The quality of the exports in a given product category can be inferred from the prices they command in world markets compared to products in the same category produced in the rest of the world (Fabrizio, Ignan, and Mody, 2006). An index above (below) one indicates above-average (below-average) quality. This approach is suitable to ascertain the quality of a countries’ given export mix—it is silent on whether this export mix is skewed toward or away from high quality products.

A country is said to have revealed comparative advantage (disadvantage) in a product if its exports of this product account for a larger share in its total exports than global exports of this product in total global exports. The classification of goods and service into labor intensive, capital intensive, and knowledge intensive categories follows Rahman and Zhao (2013, p. 40).

The calculations group global exports by product category. The fastest (slowest) growing categories that comprise 50 percent of global exports are considered globally dynamic (non-dynamic). Accordingly, countries that have more (less) than 50 percent of exports concentrated in globally dynamic product categories are considered overexposed (underexposed) to globally dynamic product categories. Natural-resource intensive product categories are excluded from the exercise because of their high susceptibility to global commodity price swings (animals and vegetables, minerals, and fuels).

The degree of GVC participation can be gauged by an index constructed as the sum of (i) the share of imported inputs embedded in exports, and (ii) the share of exports that do not stay in the country of primary destination but rather serve as input into further exports to third countries (Koopman et al., 2014, and OECD, 2012).

Analysis of the Baltic countries’ education systems is beyond the scope of this report, but a review of Latvia points to significant scope for improvement on the educational front (IMF, 2012).

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