Baltic Sea Report September 2008

Baltic Sea Report Swedbank’s analysis of the economc counditions and structure of the countries around the Baltic Sea from a corporate perspective

Swedbank Baltic Sea Analysis No. 17 25 September 2008

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, Sweden

Telephone +46-8-5859 1000, [email protected], www.swedbank.se Legally responsible publishers: Cecilia Hermansson, +46-8-5859 1588,

Jörgen Kennemar, +46-8-5859 1478, ISSN 1103-4897

Baltic Sea region shifts into lower gear, thereby reducing imbalances

• We expect the Baltic Sea economies to expand at a significantly slower rate in 2008-2009 than the last two years, with growth of around 3.5 - 4%. GDP growth is estimated at 2.2% this year and a modest 1.4% next year.

• The global economy has slowed and financial concerns have worsened. Though it doesn’t have any major economic imbalances, Germany has been infected by the rest of the world and now faces a weaker outlook for export and consumer spending. The Baltic Sea region’s largest economy will grow by only ½% next year, but technically avoid a recession.

• The financial crisis is increasingly affecting the transition economies in the Baltic Sea region. The financial sector is relatively small in relation to GDP, but when the credit expansion slows, growth does as well. Lower capital inflows through portfolio and direct investments are also affecting the real economy.

• In Russia and Ukraine, domestic demand is growing fairly strongly. Both countries are hurt by the financial crisis, and by political tensions domestically and internationally. At a time when commodity prices are falling, these countries can’t afford political instability. The importance of reform efforts is growing. Still, these countries have the best prospects in the region, with GDP growth of between 5% and 6.5% next year.

• Poland has increased its pace of reform since the election last year. More privatizations and a timetable for ERM II/EMU are part of the reason. GDP is expected to grow by 4.5% next year.

• Estonia and Latvia are headed backward, while Lithuania’s growth remains modest. Domestic demand is cooling off as households and businesses adjust their balance sheets. This is especially evident in the retail and construction sectors. Exports are being affected by weaker global growth as well. Reforms will still need to be geared toward helping competitive sectors to grow in order to reduce imbalances and improve growth potential in the longer term. One positive effect of the slowdown is a lower risk of overheating, i.e., that current account deficits will shrink and wage growth will slow, resulting in lower inflation.

• Growth prospects are also weaker in the Nordic countries, especially Denmark. The forecast for Sweden has been revised downward since August, and GDP is now expected to grow by 1.5% this year and 1.2% next year.

• The convergence in the Baltic Sea region is progressing, but not without effort. Reforms are needed to strengthen the business and investment climate. This applies to every country in the region!

2 Swedbank Baltic Sea Analysis No. 17 • 25 September 2008

Contents

Key financial ratios 3

Despite the financial crisis, there is still good potential for 4 Baltic Sea companies

Growing trade in the Baltic Sea region 14

Russia – The financial crisis is causing a shake-up 17

Ukraine – Political disagreement in a precarious situation 24

Estonia – A cooling economy with lower imbalances 28

Latvia – Shifting into reverse 32

Lithuania – A softer economic slowdown 35

Poland – Faster pace of reform 39

Germany – Trying to stay above water 44

Denmark – The housing market is cooling the economy 47

Finland – Shrinking exports 49

Norway – Slowing, but is still the fastest growing Nordic country 51

Sweden – Decelerating more than expected 53

Sweden forecast 56

Economic Research Department SE-105 34 Stockholm, Sweden Telephone +46 8 5859 1031 [email protected] www.swedbank.se Legally responsible publishers Cecilia Hermansson, +46 8 5859 1588

Jörgen Kennemar, +46 8 5859 1478 ISSN 1103-4897

The Swedbank Baltic Sea Analysis is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, directly or indirectly, owing to any errors or omissions in Swedbank’s Baltic SeaAnalysis.

Swedbank Baltic Sea Analysis No. 17 • 25 September 2008 3

Economic conditions around the Baltic Sea

September 2008 Key financial ratios 1)

GDP growth Inflation Current account Budget balance (%) (CPI, %) (% of GDP) (% of GDP)

2007 2008 2009 2007 2008 2009 2007 2008 2009 2007 2008 2009

Poland 6.6 5.3 4.6 2.6 4.3 3.3 -3.8 -4.6 -4.1 -2.6 -2.3 -2.7

Estonia 7.1 -1.0 1.5 6.6 10.0 6.0 -13.8 -10.2 -9.5 2.8 -0.3 -0.5

Latvia 10.3 -0.5 -1.0 10.1 16.0 7.5 -22.9 -16.0 -11.0 0.0 -1.0 -1.5

Lithuania 8.8 5.0 3.5 5.7 11.2 8.0 -13.7 -11.5 -10.0 -1.2 -1.5 -1.7

Russia 8.1 7.3 6.5 9.0 14.0 11.0 6.1 7.5 3.0 5.4 5.0 3.5

Ukraine 7.6 6.0 5.0 16.6 24.4 15.5 -4.2 -6.7 -9.8 -1.0 -1.5 -1.5

Germany 2.5 1.8 0.6 2.3 2.9 2.4 5.6 5.0 4.4 0.1 -0.4 -0.6

Denmark 1.7 1.0 0.5 1.9 3.4 2.5 1.1 1.3 1.5 4.5 3.8 2.7

Norway 2) 3.7 2.5 1.7 0.8 3.6 2.5 15.4 19.8 17.8 17.4 18.5 17.5

Finland 4.5 2.0 1.2 2.5 3.6 2.3 4.1 3.3 2.4 5.3 4.5 3.5

Sweden 2.7 1.5 1.2 2.2 3.7 2.3 8.4 7.8 7.5 3.5 2.6 0.9

GDP for 2007 2008 2009 Baltic Sea countries 3.6 2.2 (2.6) 5) 1.4 (2.4) 5) in total 3) 4)

1. Annual average, actual GDP growth, not calendar-adjusted.

2. Associated “analysis country.” Statistics for the total economy, i.e., both the mainland economy and oil sector.

3. Percentage increase.

4. Ukraine is not included in growth for the Baltic Sea region. Weighted based on Swedish exports to these countries in 2005. The Baltic Sea region has also been calculated exclusive of Sweden.

5. The figure from the March 2008 forecast is in parentheses.

6. Forecasting work concluded on 24 September 2008.

Sources: National statistics, Swedbank’s own calculations

Introduction


Despite the financial crisis, there is still good potential for Baltic Sea companies 1. Two years seen in slow motion for Baltic Sea economies Our new forecast for the Baltic Sea region is made at a time of financial turbulence and a revised outlook for the global economy. Growth prospects in the next two years are not as good as in the last two, when the region grew by 3.5 - 4%. Even compared with our spring forecast, the Baltic Sea region is now expected to grow at a slower pace, i.e., by 2.2% in 2008 (2.6%) and 1.4% (2.4%) in 2009. A recovery is not expected until beyond our forecast horizon; given our main global scenario it could begin gradually in 2010.

2. Global forecast revised downward Our forecast from August 14 would normally be considered fresh enough to be used as input in the Baltic Sea forecast. The major slowdown in the euro zone and escalating financial crisis have forced us to revise our global forecasts downward, especially for next year, when global GDP will grow by 3% (compared with 3.4% in August). Uncertainty is great and risks are complex.

For the rest of this year, it is not impossible that the U.S. will grow at a slightly faster rate than we estimated in August, since GDP developed more strongly than expected during the first half year due to the positive trend in net exports and the impact on consumer spending of the government’s stimulus package. On the other hand, a tighter credit market and uncertainty in the financial market mean that the slowdown next year will be even more severe.

Global growth outlook

* Approximately 70% of the global economy is covered by the above countries. A more complete accounting of emerging markets would raise annual global growth by about 0.25% in all reported years. The global economy has been weighted with the help of purchasing power parity (PPP) weights.

Two weak economic years in our region

EMU member states are decelerating and the financial crisis has worsened

September forecast August forecastGDP growth (%) 2007 2008 2009 2008 2009USA 2.0 1.7 1.1 1.5 1.5

EMU countries 1.4 0.8 1.6 1.4of which: Germany 2.5 1.8 0.6 1.8 1.4

France 2.2 1.2 0.8 1.7 1.5Italy 1.5 0.5 0.2 0.6 0.9Spain 3.8 1.2 -0.2 1.5 1.0

UK 3.1 1.4 1.0 1.7 1.5

Japan 2.1 1.1 1.1 1.2 1.3China 11.9 9.8 8.7 10.0 9.0India 8.9 6.9 6.4 7.2 7.5

Brazil 5.2 4.7 4.0 4.7 4.0Russia 8.1 7.3 6.5 7.5 6.8

Global * 4.7 3.6 3.0 3.7 3.4

Introduction


According to data presented in mid-August, Western Europe slowed considerably more than expected during the summer. The UK, Ireland and Spain are feeling the impact of a significant correction to their housing and financial markets. The three largest countries in the euro zone – Germany, France and Italy – are being affected by the relatively strong euro, high inflation, unstable financial markets and weaker global conditions, which are working together to soften the outlook for exports and consumer spending. Household and corporate confidence have fallen markedly.

Emerging countries in Asia, Latin America and Europe are also affected by the weaker global economy. It is worth noting, however, that while their growth rates are being revised downward they remain high compared with the U.S. and Western Europe. These countries are helping to raise global growth in a worldwide slump.

We haven’t changed our opinion of when a recovery might begin. Assuming that the rescue package in the U.S. is received positively and prospects of a turnaround in the real estate market improve, there is no reason to expect a slow recovery to be delayed further at this point. Still, we can expect at least a couple of years of consolidation during this period, which in the U.S. is being called a balance sheet recession.

The big fluctuations in oil prices from day to day are an indication of the risks we still see in the form of high inflation and difficulty for central banks to lower interest rates, but given the weaker economy inflationary pressures should begin to decline. Once again, U.S. actions to aid the financial sector, as well as the dollar’s development are affecting commodity prices and are an important factor in our forecast. We have assumed an oil price of USD 105 a barrel this year and USD 95 in 2009.

3. The financial crisis is increasingly impacting the region The global financial crisis has gradually had a growing impact on the Baltic Sea economies. Risk premiums are rising. GDP growth is slowing. The credit crunch is leading to lower consumer spending and investments.

Though still robust, the Nordic financial markets have been infected by higher funding costs for banks, which in turn have led to higher interest rates for businesses and households. Access to capital outside banks has also become more expensive for companies due to higher risk premiums. The stock markets are bearish. In Ukraine and Russia, a large part of the market capitalization has been lost in recent months, though equities are falling in other countries as well.

The outlook has worsened in emerging countries as well, though demand remains higher there

Commodity prices are fluctuating, but the trend is downward

In the Baltic Sea countries, the financial crisis is mainly the result of contagion…

Introduction


Stock prices in selected Baltic Sea countries, index 100 = 1 Jan 2008

Source: Reuters EcoWin

jan06

apr jul okt jan07

apr jul okt jan08

apr jul

Inde

x

20

30

40

50

60

70

80

90

100

110

120

130

140

Ukraine

RussiaSweden

Poland

Lithuania

The financial systems in the four transition economies we call the Baltic Sea Region 4, BSR4 – Estonia, Latvia, Lithuania and Poland – have been increasingly harmonized with the EU’s financial markets. While this provides them with more stable access to capital, they too are affected when lending capacity decreases in the more mature economies.

In Russia and Ukraine, the financial crisis has been fueled by political developments. In Russia's case, government intervention in the private business sector and the war in Georgia are creating uncertainty. In the case of Ukraine, conflicts in the region and political turbulence domestically have strongly contributed to the financial crisis. The stock exchanges in both countries have been forced to suspend trading when prices have swung too much.

The Baltic Sea Region 6, BSR6 – Russia, Ukraine, Poland, Lithuania, Latvia and Estonia – are less exposed to the U.S. subprime market, but are still affected through their links to the overall European financial system.

The financial sector in the transition economies is smaller in relation to GDP than in more mature economies. In Russia and Ukraine, domestic credit to private sector represents only about 30% of GDP. Thus, the financial turbulence has less effect on the real economy, since many players have other ways to finance their expansion plans.

… but in Russia and Ukraine political instability has created greater concern

The financial sector in the transition economies is relatively small in relation to GDP

Introduction


Development of the financial sector in various regions of Europe's transition economies*

* The Baltics include Estonia, Latvia and Lithuania; Southeast-E includes Albania, Bosnia & Herzegovina, Bulgaria, Macedonia, Romania and Serbia. Central-East-E includes Poland, the Czech Republic, Slovakia and Hungary. The CIS includes Russia, Ukraine, Belarus and Moldavia.

Source: Vamvakidis, A. (IMF report) (2008)

It is important to also look at the trend in credit growth, not only the level. Financial deepening is an important factor behind the successful growth in the Baltics and in recent years has resulted in rapidly expanding credit. Outstanding debt (78 %) is greater today than in many other transition economies in Europe, and is nearing that of the euro zone (122 %). As a result, less access to capital is having a greater impact on the economy than in countries where credit has expanded more modestly. Credit expansion has also been rapid in Ukraine, which began from a lower level.

The common denominator for all the countries is that the credit expansion is now slowing and that this is affecting the real economy. Credit growth rates in these countries (except Ukraine) have now dropped to 20-35%, against 30-50% previously. Ukraine's credit growth has moderated from nearly 80% to 60%, with a further slowdown expected.

Domestic lending, annual growth (%), 12-month moving average

S o u rc e : R e u te rs E c o W in

0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8

Pro

cent

-1 0

0

1 0

2 0

3 0

4 0

5 0

6 0

7 0

8 0

L e tt la n d

U k ra in a

P o le nR y s s la n dL ita u e n

E s tla n d

4. Imbalances create vulnerability to shocks Credit growth in many of Europe’s transition economies has far exceeded GDP growth, more than in other emerging countries. GDP growth has been faster than estimated growth potential. This is particularly true in Latvia, though Russia and Ukraine as well. The difference during the period 2003-2007 is a couple of percentage points.

The credit expansion is slowing and impacting growth

Baltics Southeast-E Cent-East-E CIS Euro zoneDomestic credit to the private sector/GDP (%) 78.1 38.3 45.2 31.0 122.0Listed companies’ market capitalization/GDP (%) 28.0 42.6 31.4 87.2 72.9Financial sector as constraint to growth,% of business managers

11.3 34.1 28.8 33.1 20.1

Introduction


Rapid growth has contributed to current account deficits and widening foreign debt, particularly in the Baltics, though also to an increasing extent in Ukraine. In addition, internal imbalances in the form of rapidly rising wages and inflation have created overheating.

The countries with large internal and external imbalances are more vulnerable to the kind of financial shocks we are now seeing. This increases the risk of a hard landing, as evident in Estonia and Latvia, where growth is now slowing substantially. For Poland and Lithuania, on the other hand, we expect growth to remain respectable at around 3-5%, as is also the case with Ukraine and Russia (5-6%), where the credit expansion didn’t begin to accelerate until more recently.

Current account balance and foreign debt as% of GDP 2007

Other factors have mitigated the alarming trend:

An important reason for the growing debt levels and widening current account deficits is the growing attractiveness of these countries following their successful reforms (Baltic states, Poland) or closer harmonization with the EU (Ukraine).

A large part of the growing current account deficits has been driven by higher investments. Although savings have declined, investments have risen more, which is positive for long-term growth prospects.

Foreign direct investment has financed the large part of the current account deficit, which is positive for several reasons: Flows are more stable and are creating better growth opportunities by spreading know-how. In countries where the privatization process has progressed, FDI has streamed in, while countries that have been slower to act (Russia) have found it more difficult to attract foreign capital. Poland is again accelerating the pace of privatization, which is paving the way for greater FDI.

Several years of growth over potential has led to imbalances

Countries with imbalances are more vulnerable to outside shocks

-16 -13

-4.2

5.9

-3.7

-23.3

106

129

53.4

34.4

51.3

65.8

-25

-20

-15

-10

-5

0

5

10

Latvia Estonia Lithuania Poland Russia Ukraine

0

20

40

60

80

100

120

140

Current account balance as% of GDPForeign debt as% of GDP

Introduction


Privatization, direct investment and assessment of the transition process

Source: Vamvakidis, A. (IMF report) (2008)

Despite seeing their currencies appreciate in real terms (through stronger currencies in nominal terms and/or higher inflation than in competing countries), many of the countries have captured market share globally. This applies primarily to Latvia and Poland in 2003-2007, though also Estonia and Lithuania. Russia and Ukraine have also raised their market share slightly.

We note, however, that the growing current account deficits in recent years, especially in Latvia and Estonia, have been followed by higher consumer spending growth. Domestic demand has been driven by the service sector, which is not as competitive. Loans have become more important as a source of financing for these deficits. A shift is needed so that foreign direct investment flows more to competitive sectors that strengthen exports.

5. Inflation and rising wages – problem areas now easing Inflation has risen in the entire Baltic Sea region during the last year. The main reason is the rise in energy and food prices. Food and gasoline account for a larger share of spending in transition economies than in the Nordic region and Germany, for example. In Ukraine, poor harvests have had an impact as well.

Inflation, annual increase in consumer prices (%)

S o u rc e : R e u te rs E c o W in

ja n a p r ju l o k t ja n a p r ju l o k t ja n a p r ju l0 6 0 7 0 8

0

5

1 0

1 5

2 0

2 5

3 0

3 5

U k ra in e

L a tv ia

R u s s ia

E s to n ia

P o la n d

L ith u a n ia

G e rm a n y

There are also domestic reasons related to economic policy why inflation has risen. In Ukraine and the Baltic states, fiscal policy has been expansive. Government salaries have been raised significantly,

More investments in the competitive sector

High inflation is not only an effect of high commodity prices

SE-E Central-East-E CIS FDI/GDP (%) 5.1 6.9 3.9 3.2 Transition index (1-5) 3.8 3.1 3.8 2.7 Privatizations (large-scale, 1-5) 3.9 3.3 3.8 2.7 Privatizations (small-scale, 1-5) 4.3 3.8 4.3 3.4

Baltics

Introduction


as have pensions. Energy subsidies may have been reduced, which has helped energy prices to rise more quickly. In general, rapid growth has also driven domestic demand and pushed prices higher.

Inflation has now begun to decline from very high levels. Lower global growth, lower commodity prices and a slowdown in activity in the Baltic Sea region are working together to reduce inflation. Wage growth is also tailing off, which is positive for inflation. When business activity slows and the profit outlook worsens, attention turns to efficiencies, which will make it difficult to maintain the same wage increases we have seen in recent years.

6. Many good opportunities can still be found Wage growth is now outpacing productivity in a number of countries. Unit labor costs are on the rise, which could hurt competitiveness.

However, labor costs in transition economies generally remain quite a bit lower than in the Nordic region and Germany. Moreover, we expect wage growth and labor costs in transition economies to slow going forward.

Growth in the Baltic Sea region will slow in the next two years, but this doesn’t mean there aren't good business opportunities in the region. Integration and specialization continue. Income per capita in transition economies is still quite a bit below the EU and euro zone average. Convergence with more mature EU member states will continue, even if the boost from the reform process in connection with EU accession is gradually subsiding. (Bulgaria and Romania, for example, are now getting a bigger boost than Poland.)

We estimate potential growth in the Baltics at between 4.5% and 6%, and 4-5% in Poland. In Ukraine and Russia, potential growth is 5% to and 6%. These figures are uncertain and assume that economic policies don't radically change, although an accelerated reform process could stimulate even higher potential growth.

Given that the euro zone is growing by 2%, it would take between 15 and 20 years for the Baltics and Poland to converge with the euro zone, while it would take nearly twice as long, 30-35 years, for Russia and Ukraine.

Lower inflation is in the cards

Production costs still differ widely

Our region still offers many good business opportunities

Convergence continues, but will take many years

Introduction


Real GDP per capita in relation to euro zone (%) 2003-2007

The above diagram can lead to several important assumptions for businesses in the Nordic region and Germany:

Large income gaps will remain between countries in the region, providing opportunities for division of labor and specialization.

We shouldn’t forget that there are large, and sometimes growing, income gaps within every country in the region.

All the countries are in need of infrastructure investments, which will facilitate integration if and when they are made.

Middle-class spending in transition economies is steadily growing, though not as quickly as in recent years. Design, marketing, customer relations and smart distribution solutions remain important in order to compete for these growing customer groups.

Environmental and climate changes are placing new demands on companies in the region. The specialization wave continues, but freight transports must be handled in an environmentally safer manner. Moreover, carbon offsets will become more costly in transition economies where less renewable energy is available, such as Poland. This raises production costs.

7. Transition economies and the EU are converging, but not without effort

The impression you sometimes get from various experts, particularly in the financial market, is that the convergence between new and existing EU member states is a given. Interestingly, studies show that convergence is contingent on institutional and demographic developments, human capital and economic policies (especially structural policies). Studies by the IMF, however, show that these conditions haven’t impacted the convergence process for new EU member states. The reason is the integration within the EU (financial markets, trade flows, etc.).

EU integration has accelerated convergence …

30.5

60.6

26.9

56.8

0

10

20

30

40

50

60

70

Baltics Southeast-E Central-East-E CIS

Real GDP per capita (2007) of euro zone,%

Introduction


For the convergence process to continue in the same successful way will now require more reforms, not least in order to increase the growth contribution from the competitive sector and reduce external and internal imbalances. It isn't a given that the new EU member states will catch up with the euro zone in 15-20 years; that depends to a growing extent on economic policies that are adopted.

Examples of reforms needed in every country in the Baltic Sea region:

Demographics: Open up to foreign labor with the skills to increase specialization. Many people are now returning to transition economies from the UK and Nordic region, but the long-term challenge is to create a more open attitude.

Reforms that encourage older citizens to continue working and make it more attractive to hire young people.

Reforms that increase R&D in every sector and improve education at other levels.

Investments to improve infrastructure nationally and help bring the region closer together.

Greater focus on competitive issues within and between countries.

Any conceivable measure that improves the business and investment climate.

With respect to the last point, it can be helpful to look at the World Bank's annual review of how easy/expensive it is to do business in each country. Denmark and Norway stand out as most attractive countries in the Baltic Sea region. Among transition economies, Estonia ranks the highest, though Latvia and Lithuania aren’t far behind. Ukraine and Russia have a long way to go and have seen their positions fall. Weak institutions, corruption and bureaucratic obstacles remain a problem. Poland should also be able to improve its ranking.

Sweden is losing ground to Saudi Arabia, Georgia and Thailand, which have joined the list. Germany is losing ground as well, including to Mauritius. The ranking is retrospective, and other surveys may be more positive. It does show, however, that it is important to always look forward and to try to improve institutions and ease regulations.

Ranking the ease of doing business (2009)*

1. Singapore (1) 2. New Zealand (2) 3. USA (3) 4. Hong Kong (4) 5. Denmark (5) 6. UK (6) 7. Ireland (7) 8. Canada (8) 9. Australia (10) 10. Norway (9) ----------------------------------

---------------------------------- 14. Finland (13) 17. Sweden (14) 22. Estonia (18) 25. Germany (20) 28. Lithuania (28) 29. Latvia (26) 76. Poland (72) 120. Russia (112) 145. Ukraine (144)

* Figures in parentheses are from the 2008 report

8. Foreign exchange policies are important Current trends in the foreign exchange arena are potentially of major importance to companies. The currencies of the Baltic states are

… but the effects are subsiding and more reforms are now needed

Sweden is slipping in the ranking – competition is growing

The BSR4 will soon join ERM II …

Introduction


pegged (one-way) to the euro through their ERM II arrangements. To avoid protracted acceptance into ERM II, these countries have to work aggressively to reduce inflation. Current account deficits are another area in the analysis of Maastricht criteria. We expect the most likely timetable for EMU accession to be 2012-2016 for the Baltic countries, with Estonia and Lithuania as the earliest candidates.

Poland is in the process of joining ERM II and has a timetable starting in 2009. Membership in EMU could come as soon as 2011, but is more likely in 2012 or possibly 2013.

Russia and Ukraine have a so-called managed float, where the ruble and hryvnia are pegged to a basket of currencies primarily consisting of the dollar and euro. Their central banks are gradually opening up to give their currencies more flexibility, which will be easier when capital inflows slow and appreciation pressures ease. Instead, inflation targets will be more important to economic policy, and consequently to the interest rates set by central banks. The transition is under way, but obstacles may still arise. The Russian central bank, for example, recently felt forced to reduce depreciation pressures. If appreciation pressures arise again, various stakeholders will fight to reduce them. The battle for the central banks – which want to change policies – is not yet over.

The timetable to issue two essentially opposing monetary and foreign exchange targets (currency and inflation) is basically fine. We are likely to see a gradual change where Ukraine adopts a wider range in which its currency is allowed to float. To date, the policies in both countries have failed to keep inflation in check. It is possible that central banks will only be able to fight inflation if capital inflows decline, commodity prices drop and fiscal policies become less expansive (especially since budget deficits are becoming more difficult to finance).

9. Baltic Sea region is becoming a more important export market

Jörgen Kennemars’ analysis in the next section shows that the BSR6 have become increasingly important to Swedish exports in the last decade. The Baltic Sea region is the recipient of 40% of Swedish exports of goods. As domestic demand has grown in these countries, trading patterns have changed, with machinery and equipment accounting for a higher share of exports.

Sweden is managing fairly well to maintain market share in the region, but there is room for improvement. It is losing ground, for example, in the Nordic markets, as well as in Latvia and in Russia. Swedish companies usually aren't able to gain market share in sluggish markets, so it is an especially big challenge in this business cycle to increase their presence and build relationships.

Cecilia Hermansson

… while Russia and Ukraine are gradually increasing the flexibility of their currencies

Weaker demand in the Baltic Sea region will be reflected in Swedish exports

Trade patterns


Growing trade in the Baltic Sea region The Baltic Sea region is the recipient of 40% of Sweden’s total exports of goods. The Baltic Sea market is even more important to the country’s small and medium-sized companies, which often utilize this geographical proximity as a springboard to more international business. Sweden is not unique in this respect; Denmark and Finland have also channeled a large share of exports to the region. The value of exports to the Baltic Sea countries from all the Nordic countries has increased significantly in the last decade.

During the period 1995-2007, the value of Swedish exports to the Baltic countries, Poland, Russia and Ukraine rose five-fold and comprised 6.5% of its total exports in 2007, compared with 2.8% about a decade ago. For the region as a whole, the figure has risen from 35.6% to 39.7%. As these new countries have increased in importance, Germany’s share of Swedish exports has declined.

Despite fears of weaker growth and greater uncertainty in financial markets, Swedish trade with the Baltic Sea countries continued to grow at a fair pace during the first half of the year. In total, Swedish exports to the region rose by 11.7% at an annual rate. Exports are growing most quickly to key Nordic markets and Russia. Exports to Poland also continue to grow rapidly. In the Baltic states, weaker domestic demand has had an impact on Swedish exports. Exports from Sweden to Latvia and Lithuania have noted a decline.

The economic integration in the Baltic Sea region is stimulating trade. Exports and imports between countries have increased in pace with the growth in the region. We expect this trend to continue even if the short-term trade outlook is slightly worse at present due to weaker economic conditions. Against the backdrop of improving economic standards in the region, particularly in transition economies, there are still good opportunities for regional businesses.

Export patterns are changing as purchasing power grows and new industries gain a foothold. We can see this trend by studying how Swedish exports to these countries have changed over time.

We have analyzed the distribution of Swedish exports to the region by product group for the period 1995-2007. We have chosen to study exports to the Baltics, Poland, Russia and Ukraine, a geographically proximate market with great Swedish export potential.

As an export market, the region is growing in importance

The trend toward more extensive trade continues

Trade patterns


Swedish exports of various product groups to transition economies in the Baltic Sea region

0

10

20

30

40

50

60

Commod

ities

Chemica

l prod

ucts

Interm

ediat

ed go

ods

Machin

ery/eq

uipmen

t

Variou

s fini

shed

good

s

199520002007

Source: Statistics of Sweden During the above-mentioned period, Swedish exports to this market increasingly shifted to machinery and equipment. In 1995, this product group accounted for slightly over 40% of the total export value to these six transition economies. Last year, the figure rose to 50%.

The change in Swedish trade is partly due to the strong growth in purchasing power in the region in recent years. In the Baltics, Russia and Ukraine, the concentration is higher.

In the Baltic countries, per capita purchasing power has risen from 30% in the mid-1990’s to around 60% of the EU average. At the same time, investments have grown strongly, because of which demand for electronics and transportation equipment has increased as well. Raw materials and various finished goods have declined in importance, while exports of finished goods are relatively stable at around 20%.

The large exposure to capital goods makes Sweden vulnerable to major economic fluctuations. Against the backdrop of the darkening growth prospects in the next 12-18 months noted in the Baltic Sea Report, there is an increased risk of weaker demand for capital goods and thus a declining market for Swedish export companies in the Baltic Sea region.

Have these market share changed? Several studies show that Sweden is losing market share, particularly in key high-volume markets in Europe. In the Baltic Sea region, Swedish companies have been able to defend their market share relatively well in recent years. Latvia and Russia are exceptions. In the Nordic countries, especially Finland and Norway, both big markets, Sweden has been unable to defend its high market share. This trend has continued for some time.

Demand for capital goods has increased

Trade patterns


Swedish market share in various countries (Swedish exports as % of each country’s imports)

Source: National statistical agencies Conclusions:

Swedish exports to the Baltic Sea region’s transition economies have grown from around 2.8% in 1995 to 6.5% in 2007.

The growing importance of capital goods to Swedish exports

is also reflected in trade with the Baltic Sea countries. Raw materials and finished products have decreased in importance, on the other hand. Increased buying power and strong investment growth in the Baltics, Russia, Poland and Ukraine have created an increasingly important market for Swedish exporters.

Weaker growth prospects and a slower investment rate in the

next two years could adversely impact export opportunities for Swedish companies.

Swedish market share in the Baltic Sea region remained

relatively stable during the period 2004-2007. Latvia and Russia were exceptions, however.

Jörgen Kennemar

2004 2005 2006 2007Germany 1.8 1.8 1.7 18Finland 10.9 10.6 9.8 9.9Norway 15.7 14.3 14.9 14.6Denmark 9.7 8.9 8.9 10Estonia 13.4 13.9 14.1 14.4Lithuania 2.7 3.4 3.3 3.7Latvia 6.3 5.1 5 4.9Russia 2.7 2.3 1.9 1.8Ukraine 1.4 1.5 1.3 2.3

Russia


Russia – The financial crisis is causing a shake-up Population: 141.6 million GDP per capita 2007: USD 14,400 Government: Market-oriented coalition Prime Minister: Vladimir Putin President: Dmitry Medvedev Next parliamentary election: 2011 Next presidential election: 2012 Average GDP growth in last five years: 7.3% Average inflation rate in last five years: 11.1%

Summary Russia’s financial crisis is rooted in domestic politics, falling

commodity prices and global financial turmoil. While the Russian financial sector is of limited importance to business and consumer spending, foreign capital is increasingly important to the economy. As a nation, Russia appears to have sufficient financial muscle to reduce these concerns.

Domestic demand continues to develop strongly. GDP is expected to grow by 7.25% this year and 6.5% next year. The slowdown is due to high inflation, slowing credit growth, lower commodity prices and a weaker global economy.

The investment climate has cooled, but opportunities for foreign companies remain good. The market continues to grow thanks to an expanding middle class and service sector as well as investment programs to improve Russian infrastructure.

Consequences for Baltic Sea companies - Consumer spending could see double-digit increases this year and

next. This also applies to the investment rate, which is declining from 20% last year to 10% in 2009. The retail and construction sectors are also chugging along despite slowing growth. Attractive business opportunities can be expected in the Russian market in the years ahead.

- For foreign companies with production in Russia, a tighter job market is evident in high wage increases and employee turnover and the difficulty to find qualified workers.

- High inflation is also evident, but as commodity prices decline and capital inflows drop inflation will slow from 15% to 11% next year. It will take several years before inflation reaches as low as 6-7%.

- The extensive 10-year investment program in infrastructure and housing will consume a large chunk of the budget. The president’s goal is to increase the share of homeowners from 20% to 35% of the population by 2012. Demand for foreign companies to

Russia


implement projects is growing. There are good opportunities, for example, for Nordic and other Baltic Sea companies that are willing to join together to better compete in procurements.

- Russia needs foreign environmental technology companies to meet climate and environmental requirements. Demand is strong, but not enough foreign companies seem interested so far.

- Economic development is also improving in the country’s regions. The middle class is growing in a number of big cities. Bottlenecks in the labor market shouldn't hamper production here, either.

- The central bank continues to try to stabilize the ruble. Fluctuations will continue as long as the financial crisis does. In the slightly longer term, monetary policy will focus on inflation and discount rates, while the ruble is allowed to rise or fall. As the current account surplus shrinks and capital inflows slow, it will be easier to change policy in this way.

The state is playing a greater role in the economy The summer months provided little relief. On the contrary, they were an intense period for the new Russian president, Dmitry Medvedev. The administration’s political and military actions have contributed to Moscow's declining stock prices, capital flight and a weaker investment climate. The global financial crisis and falling oil prices have certainly helped. Flexing its economic muscles and going its own way in terms of foreign policy helped Russia’s self-confidence, but negative reactions from international financial markets couldn't be avoided.

On July 24, Prime Minister Vladimir Putin attacked steel and coal producer Mechel, which is listed on the New York Stock Exchange, alleging that the company was abusing its market position. The language he used was threatening and fines were levied, reminding investors of the oil company Yukos. The share plunged by 38% and the Russian stock market cooled off. The Russian administration’s intervention in the private sector, as well as its support for state-owned companies, is creating greater political risk for foreign investments.

At the same time, the CEO of BP’s Russian operations, Robert Dudley, and several of his colleagues were forced to leave the country after their visas were not renewed. This raised uncertainty about the venture between Russian TNK and BP, a mishmash that mainly involves private players but where the Russian administration did little or nothing to assist BP. An agreement has now been reached to appoint a new chief executive and list the company separately on the stock exchange, creating prospects of further alliances for this oil company, Russia’s third largest.

The main event during the summer that affected views of Russia from a security standpoint and of its investment climate was the invasion of South Ossetia and war with Georgia, which broke out on August 8.

Russian politicians have helped to create a chillier market climate

Russia


Russia, which has not received international support for its recognition of South Ossetia and Abkhazia as independent republics, claims that the conflict between Georgia and these two areas dates back many years. Comparisons were drawn with Kosovo’s independence from Serbia. The EU and the U.S. instead have stressed Russia’s failure to resolve the conflict diplomatically and the excessive violence it used. Russia’s declaration that it will protect Russians no matter where they live has created concerns in elsewhere in Europe, particularly the Baltics and Ukraine, where there are many Russian natives. Although its military is now leaving the area, there is still uncertainty about Russia's intentions in Caucasus. There are also questions about Georgia and Ukraine’s efforts (not among all those accepted) to join NATO, as well as NATO's placement of missiles in Poland and Czech Republic, actions which have provoked Russia.

The war in Georgia – and the Russian administration’s actions against private companies – has created great uncertainty in financial markets and among some foreign investors.

Uncertainty about Russia’s development is exacerbated by the substantial drop in oil prices and global financial crisis. A lack of liquidity was also reflected in higher interbank market rates (over 10% against 6% a month ago), which forced the central bank to allocate 31 billion euro of the national budget to Russia’s three largest banks (where the state is the majority owner): Sberbank, VTB Bank and Gazprombank. The central bank has also reduced reserve requirements by four percentage points until February of next year. Additional funds were allocated to equity markets. The state invests in foreign stocks, but is also discussing whether to buy shares in domestic companies. The state is increasing its involvement in the private sector. As a whole, USD 130 billion has been targeted for the financial market, and concerns have subsided. Small banks are still having problems with liquidity, however.

We expect these developments to have both financial and economic consequences, although they are difficult to quantify:

The Russian stock market (both Micex and the dollar-denominated RTS) have lost half their peak valuations in May. Fluctuations have increased, and if prices change by more than 10% the Moscow Stock Exchange suspends trading, as happened recently. Since the state provided capital to the banking sector and equity markets, stock prices have risen substantially, though uncertainty remains. The stock and bond markets account for only a few percent of the financing of corporate investments, but are growing in importance.

The ruble has lost approximately 7% against the dollar since the beginning of August and slightly over 5% in the last month alone. This was the largest monthly decline since spring 1999.

Capital is flowing out instead of in. Analysts estimate that more than USD 20 billion has left the country since the beginning of August, while the central bank’s figure is USD 5 billion. In 2006 and 2007, foreign direct investment (FDI) rose substantially, but this year the EBRD expects a

The war in Georgia has shaken the financial market and created uncertainty in Europe

The Russian administration has tried to alleviate the shortage of liquidity

Russia


negative net flow. FDI as a share of GDP and per capita is also small (about one seventh that of other transition economies).

It is more difficult now for Russian companies to secure or renew foreign loans. Investments are being affected, and consumer spending is also being increasingly driven by credit growth. At the same time, it is worth noting that no more than one fourth of Russian investments are financed through the financial sector, so the effects in the short term don't have to be so severe.

After 15 years of negotiations, Russia’s membership in the WTO could be delayed further. Russia has shown interest in the WTO, but isn't prepared to pay an unlimited price. Outstanding contracts could be torn up. As long as Russia remains outside the WTO, trade and investments will be tinged with uncertainty. The reform process could also be affected.

If security tensions remain high, there is a risk of higher defense spending in Russia and other countries.

Russia’s already tight labor markets will be adversely affected if the conflict with Georgia shuts out immigrants from the region.

Moreover, worries about the EU's dependence on Russia as an energy source may force the region to further diversify its suppliers. This naturally takes time, so the effects on Russia will be long term. In the near future, Russia could find it difficult to meet its natural gas commitments, especially if deliveries to China begin. In time, however, the EU’s interest in other energy sources will increase – not just for national security reasons but also because of the need to develop energy sources that do not harm the environment and climate.

The impact of foreign policy and defense concerns on the reform process depends on your viewpoint.

On the one hand, there is a risk that the domestic reform agenda will have less chance of being put into action if the foreign policy agenda takes greater precedence. Isolation on security issues could spread to economic policies, with more controls and less liberalization.

On the other hand, there is the possibility that the administration will try to counterbalance negative opinions about the country and its financial market with greater efforts to strengthen investment climate. Some experts feel that “liberals” in the administration could have more freedom if other, less reform-minded groups are preoccupied with security issues.

In summary, there is great uncertainty about the new president’s ambitions and ability to set his own political platform.

Economic conditions – domestic demand is growing in importance It is still too early to determine how the recent financial turbulence will affect Russian growth. Through July, GDP grew by 7.9% compared with the same period last year. This marks a slowdown from the first quarter of 2008, when annual growth was 8.5%. In other words, the slowdown began before the financial crisis struck.

In June and July, investments fell from a high level, although growth rates remain in the double digits. On the other hand, the manufacturing sector has lost steam and the construction industry is operating at less than the record pace of earlier this year. Retailers

Growth was slowing even before the latest financial crisis

Russia


are still growing quickly, though slightly slower than in the first quarter, when the trend in real disposable income was also stronger.

The Russian economy is chugging along. Prospects for the current year are good. Our projection that GDP will grow by 7.3 % could be exceeded since growth in investments and spending remains high. We expect domestic demand to be a more important contributor to the economy’s development as the energy sector shrinks in importance. Despite strong growth in consumer spending, this share of GDP remains constant. It is mainly the investment ratio that is rising, while net exports are of less importance. Exports have rebounded this year due to the huge increase in global commodity prices.

The underlying trend is that imports are growing more quickly than exports at the same time that tax policies are providing little incentive for energy extraction. Russian oil production has stagnated despite favorable prices, which is probably a consequence of insufficient infrastructure investments in recent years.

The outlook for 2009 is good, though slightly weaker. GDP is expected to grow by 6.5%. Now the uncertainty in these estimates is on the downside, however. Domestic demand is maintaining a high growth rate, but not as high as in 2006-2008. It is important to realize that Russia's structural transformation with a growing middle class has a great impact on growth. The service sector now taking shape is affecting production and spending patterns. There are several reasons why the Russian economy will shift into lower gear next year (with a continuation into 2010) after the boom of recent years:

A stronger dollar and global economic slowdown are likely to temper the rise in commodity prices. It will also slow growth in domestic demand due to the impact of commodity prices on budgets, financial markets and the resources available to Russian companies for investment.

Though gradually declining, the high inflation rate (currently about 14%) is still affecting real household income and business costs. In addition, capacity utilization is already high, and would be hard to expand quickly enough to reduce bottlenecks.

Credit is tighter as a result of the global financial crisis and less favorable stock market and investment climate. A stronger dollar and weaker investment climate could make it more difficult for Russians to borrow in the international market.

Economic policy could make a difference With rising commodity prices contributing to strong profits and bolstering the Russian public sector, economic policy hasn’t played an important role in recent years. As the investment climate cools, commodity prices retreat and the global economy downshifts, the Russian administration will have to put greater emphasis on sound macroeconomic policy while increasing reform efforts.

Domestic demand continues to grow strongly…

… but the uncertainty in the forecast is on the downside

Reform policies are now increasing in importance

Russia


1. Monetary and foreign exchange policy Russian monetary policy has two objectives at the same time, an approach that is problematic and unsustainable in the long term. One is to limit inflation (to 5-6% by 2010) and the other is to keep the exchange rate fairly stable against a basket of currencies (dollar and euro). Interventions to stabilize the currency when capital inflows are high increase the money supply and raise inflation. Interest rate hikes and higher reserve requirements have not been enough to compensate for the interventions. The central bank’s key interest rate is now negative in real terms. The goal to stabilize the currency has taken precedence of late.

At the same time, the banking sector’s development has contributed to higher credit growth, which has increased the debt held by businesses and households. This, too, is leading to higher inflation, by raising domestic demand, which is outpacing supply. Un-employment has been cut nearly in half from 10% in 2000. Nominal and real wages are both positive and are growing faster than productivity.

The current account surplus is likely to turn into a deficit in a few years, increasing the country’s dependence on foreign investment and loans. To maintain a surplus in 2010-2011, oil would have to stay above 100 dollars a barrel. Currency reserves, which are estimated at USD 720 billion next year, are expected to grow more slowly, but so will inflationary pressures, making the central bank’s work that much easier. As a result, it will gradually be able to shift emphasis to a clearer inflation target and away from the exchange rate. This change in policy is expected to be fully implemented by 2011. Interest rate setting will then become more important as well. In the interim, the central bank will be forced to juggle the pressures of avoiding a major depreciation as the investment climate cools and avoiding a substantial real appreciation that would hurt the country competitively. Fluctuations in the foreign exchange market will continue in the near term.

2. Politics is impacting competitiveness Businesses’ unit labor costs are rising ever faster due to high inflation, bottlenecks in the labor market, high wage increases and insufficient improvements in productivity. Russia’s competitive problems have more to do with quality, design, consumer preferences and marketing than price, however. As the stronger ruble and higher wages give households greater international purchasing power, imports of consumer goods will grow that much faster. As a result, domestic businesses will have to better compete with their international counterparts. This doesn't mean competing with Asia's low-cost production. Increasing the value-added in production is the key. The Russian population is well-educated, but there is still a shortage of qualified labor, which is leading to substantial wage increases, particularly in large cities. One potential alternative is to improve conditions for foreign direct investment and foreign labor.

A major study conducted in Russian shows that between 10% and 45% of industrial companies are competitive, but largely because of their cost advantages, which will shrink as the benefits of available capacity disappear. Investments in infrastructure and equipment will

The central bank wants to get rid of its conflicting targets

Russia could be facing a current account deficit

Russia’s competitive problems concern quality more than price

Few companies can compete internationally

Russia


increase costs. One test is the aircraft and automotive industries. Auto production is growing, but is centered on the domestic market. Here as well, there are difficulties finding personnel, and wage demands are high. Investment needs are great and costs are rising.

Russia is trying to invest more in research and development (R&D), which currently represents a relatively high 1.5% of GDP. Financing is provided almost entirely by the state, however, and the money is used in the military sector. In the rest of the business sector, there is far too little value-added production, nor is Russian industry trying hard enough to copy its competitors, which otherwise is one way to make up lost ground.

Structural reforms aimed at improving Russia's competitiveness are in the pipeline. President Medvedev has mentioned four key “i’s”: institutions, infrastructure, innovation and investments. To implement these areas will require reducing taxes, eliminating bureaucratic barriers and encouraging private investment in the social sector. It remains to be seen how these strategies will be put into practice.

3. Fiscal policy To date, Russia has used its export revenues in a disciplined manner. Foreign debt has been paid off, financial markets have developed and salaries for state employees have risen. Now demand is growing for public investment and spending. At the same time, the revenue side of the budget will be impacted by declining commodity prices and slowing growth rates. Nor will it be possible to tax the commodity sector as aggressively as in recent years, which would stifle any incentive to increase production.

In earlier years, a balanced budget could be achieved with an oil price of 30 dollars a barrel, but now the figure is closer to 60-70 dollars. This is still a good bit below the current price level, but the increase shows how quickly higher investments and spending can eat away at a budget. Russia has built up a stabilization fund, so the problems for the national budget if commodity prices fall are considered long-term. One challenge is to raise energy prices for businesses and households to a level more in line with global market prices. Excessively low prices lead to higher consumption, which will eventually make it more difficult to meet demand. Even today, Russia has to import gas to meet its export commitments. Domestic energy efficiency will therefore be an important issue, as it is for all EU member states. Other important issues are the liberalization of the natural gas market and helping domestic producers to become profitable.

Concerns that fiscal policy is pro-cyclical, i.e., that it adds fuel to an already strong economy, should subside, but are still justified. Russian policy should therefore focus on alleviating bottlenecks on the supply side by investing in education, R&D, infrastructure and improving the functionality of various markets. This is money well spent!

Cecilia Hermansson

R&D spending is high, but goes to the military

Hope lies with the president’s four “i’s”

In earlier years, a balanced budget could be achieved with an oil price of 30 dollars a barrel, but now twice that is needed

Ukraine


Ukraine – Political disagreement in a precarious situation Population: 46.4 million GDP per capita 2007: USD 6,810 Government: Market-oriented coalition Prime Minister: Yuliya Tymoshenko President: Viktor Yushchenko Next parliamentary election: 2010 Next presidential election: 2010 Average GDP growth in last five years: 7.9% Average inflation rate in last five years: 9.9%

Summary Ukraine’s growth prospects remain solid, though not quite what

they were in 2006-2007. We expect GDP to grow by 6% this year and 5% next year, against 7.6% last year.

Political events will become increasingly important now that the economy doesn't have the same wind at its back and the region has been upset by conflicts. Challenges include high inflation, a growing current account deficit, energy consumption and competitiveness, as well as the monetary and foreign exchange policies. Politicians have to try to come to agreement and accelerate the pace of reform efforts.

Consequences for Baltic Sea companies - Consumer spending and corporate investments in Ukraine are

rising, but weaker global economic conditions, lower commodity prices and credit growth are slowing the pace slightly. This presents many new opportunities for foreign companies.

- Ukraine has the opportunity to become a world leader in the agricultural and food sector. Foreign direct investment in this area is likely to increase significantly in the years ahead.

- Foreign exchange policy has failed to keep inflation in check. There are those who have therefore pushed for greater flexibility and encouraged the central bank to introduce an inflation target. This could take a few years, but during that time the central bank will make changes (quietly or directly) that could affect foreign companies.

- The political turbulence is not particularly noticeable among foreign companies, but in the longer term it is important that reform efforts stay on track. It is likely that the already slow privatization process will be affected, but other important reforms that could improve the business and investment climate may also be delayed.

Ukraine


Politics are making a bigger difference to the economy Ukrainians have gotten used to political crises in recent years. The economy has rolled along despite the turbulence. This, of course, was while economic conditions have been good, with rising steel prices, a growing global economy and strong lending growth to Ukrainian households and businesses. Going forward, economic prospects are not as good. Political developments will be of greater importance to both the investment climate and reform efforts. It is problematic therefore that the orange coalition has collapsed. After adopting a number of laws that limit his power, President Viktor Yushchenko’s party decided to dissolve the government. His popularity has declined significantly and his status has weakened.

If a new government cannot be formed by mid-October, the president has the right (though not the obligation) to call a new parliamentary election, which would be the third in three years. Yushchenko and Tymoshenko’s parties both want liberalization and closer ties to the EU. The opposition is led by Viktor Yanukovich, the former prime minister. A coalition between his party and Prime Minister Yuliya Tymoshenko’s is an alternative that could form a strong majority. Their political differences are so great, though, that such a coalition probably wouldn't last. Since Yushchenko has little to gain from an early parliamentary election, it is likely that some form of new coalition will be formed behind the scenes before mid-October.

The conflict between Russia and Georgia had repercussions in Ukraine. The coalition couldn't agree on a statement. Yushchenko accused Tymoshenko and her party of taking Russia’s side and trying to win Moscow's support leading up to the next presidential election in 2010. Tymoshenko countered that she was trying to be neutral. Yushchenko openly supports Georgia's president, Mikhael Saakashvili, and has stated that Ukraine will not renew Russia’s lease for its Black Sea Fleet base in the Crimea when it expires in 2017. The Crimea is sensitive because so many native Russians live there, and around 200,000 have received passports from Russia.

President Yushchenko wants Ukraine to join NATO. Not everyone supports him. About 20% of the population is ethnic Russian, and other segments are against him as well. Russia says it will not accept that NATO’s sphere of interest expands eastward. Neither it nor Ukraine anticipate a Russian attack on Ukrainian territory. The business sectors in both countries are intertwined and are anxious to avoid a conflict. Moreover, it is unlikely that NATO would accept a member that risks taking Russia‘s side.

Ukraine is an important country for the EU, not least because of its size and role as an intermediary for Russian natural gas. The EU and Ukraine have recently signed an agreement to expand trade, and next year they expect to eliminate the need for visas between the two countries. No agreement on future membership has been entered into. Ukraine is trying to become a member by 2020. Although the EU is far from unanimous whether to make any concrete commitments, there is a consensus on increased trade. Sweden, Poland and the UK want to see closer cooperation, while Germany and Italy are more hesitant and are worried about relationships with Russia. Unlike

People are used to political turbulence

The question is whether or not the president will decide to call for a new election

The president is more NATO-friendly than his prime minister

Ukraine


membership in NATO, Russia does not object to Ukraine becoming an EU member.

Continued turbulence in the Ukrainian parliament would delay important reforms, including those that could improve the business climate and attract foreign investment. Ukraine has to reduce inflation, limit its current account deficit and use energy more efficiently. Negotiations with Russia on gas prices are a key. In terms of national security and foreign policy, Ukraine has to stabilize its political situation at home. Political instability also worries the financial market. Risk premiums are rising.

The economy is slowing GDP rose by no less than 10.9% in August due to very strong growth in the agricultural sector after the harvest far exceeded the previous year. On the other hand, industrial production fell – primarily in metals and chemicals – by 8-9% compared with the same month last year. During the first eight months of the year, GDP growth was 7.1%, slightly below last year's 7.6%.

We expect GDP growth to slow further, to 6% this year and 5% next. The reason is a slipping current account balance now that steel and grain prices are retreating at the same time that natural gas prices are rising. Credit growth is also slower, which will restrict investments and spending slightly. Exports are expected to grow by around 4-5% in 2008-2009, but imports are climbing even faster this year, at around 15%, with a slowdown expected next year. Imports still exceed exports. Investment growth dropped from 20% last year to 12% this year, with 6% expected next year when the economy slows and access to liquidity from financial markets decreases.

Household income is growing more slowly in real terms due to the high inflation, but remains a healthy 8% (compared with 15-20% in recent quarters). Unemployment has fallen from slightly over 10% in the early 2000’s to 6-7% now. We expect the budget to be less expansive going forward, which will impact income growth. Retail sales will rise, but earlier double-digit growth numbers will be hard to repeat. The same is true of consumer spending as a whole.

Inflation has begun to retreat from very high levels. In May, consumer prices rose by about 31% on an annual basis, but in August that dropped slightly to 26%. Lower food prices are driving inflation down, and eventually lower oil prices will help slow the rise in producer prices. In September, however, gas tariffs pushed the CPI 14% higher. For the year as a whole, the CPI should drop to 25%, and for 2009 will continue downward to 14%.

Changes in monetary and foreign exchange policy Ukraine is experiencing a dramatic shift in external balances. In 2004, it had a current account surplus of slightly over 10%, but by next year that could change to a deficit of 10%. This is due to growing domestic demand and a stronger currency which are driving up imports, higher energy prices, weaker global economic conditions and pressure on export prices. Becoming a member of the WTO this year will not have a direct impact on the current account balance short-term, but in the

The most important question is whether important reforms will be postponed

We expect to see a slower growth rate

Despite falling short of previous double-digit growth, retail sales are expected to maintain a fast pace

High inflation is problematic, but has begun to fall

Expect a much poorer current account balance

Ukraine


long term domestic producers will face growing competition, though at the same time food exports may receive a boost.

Even though the current account deficit is financed with FDI and debt capital, the picture is more worrisome when looking at the details. A small percentage of FDI is spent on machinery, equipment, telecom and other infrastructure that could contribute to higher value-added and better export opportunities, whereas the majority goes to the financial and real estate sectors. This shows the importance of improving the investment climate. Ukraine’s business sector is raising new debt at a rapid rate, but the financial crisis could mean a setback that affects growth. If lending in foreign currency were to rise as rapidly, it could eventually threaten macroeconomic stability if the hryvnia weakens for any reason, rather than rising as it has recently. The central bank intends to reduce the dollarization of the economy.

Credit growth is slowing from a very high level of around 75% in late 2007 to 60% in July this year. The global financial crisis is having an impact. The cost of insuring risk in Ukraine is rising, the stock exchange has been forced to stop trading due to large fluctuations and the underlying trend for equities is lower as both foreign and domestic players abandon the market. Low liquidity is evident among domestic banks, while their foreign-owned rivals generally face a more favorable situation. They currently account for 37% of capital, compared with just under 10% in 2004.

The hryvnia has faced upward pressure due to large capital inflows and export revenues, but in the last month the trend has reversed as liquidity declined and financial concerns affected sentiment. The central bank appreciated the currency in May by loosening the fixed exchange rate to 4.65-5.04 hryvnia/USD from 4.95-5.25. Foreign exchange policy hasn’t helped the fight against inflation, since attempts to attract foreign currency in order to stabilize the hryvnia have increased the money supply and boosted inflation. Changes in monetary and fiscal policy are expected to allow the currency to float even more, at the same time that a clearer inflation target will serve as an anchor. The first step would be to further loosen the range in which the hryvnia is allowed to float.

Fiscal policy could also assume greater responsibility in reducing the high inflation rate. In reality, the opposite has been true, because the government has significantly raised wages in the public sector and pensions. The political crisis is also causing uncertainty. In the short term, budget work will be facilitated by strongly higher revenues owing to the growing prosperity of businesses and households; risks could increase over time, however. The privatization process is being affected by the political turbulence. Thus far this year, privatizations have generated 350 million hryvnia in revenue, whereas 8.9 billion had been hoped for. It has also become more difficult for the government to finance the budget deficit due to the financial crisis, which in and of itself could contribute to tighter fiscal policy.

Cecilia Hermansson

Also keep an eye on which sectors receive foreign investment

The financial market is not as liquid and credit expansion is slowing

Less capital inflows reduce appreciation pressure on the hryvnia

A responsible fiscal policy is needed to fight inflation

Estonia


Estonia – A cooling economy with lower imbalances Population: 1.3 million GDP per capita 2007: USD 19,810 Government: Conservative coalition Prime Minister: Andrus Ansip President: Toomas Hendrik Ilves Next parliamentary election: March 2012 Next presidential election: September 2011 Average GDP growth in last five years: 8.1% Average inflation rate in last five years: 3.9%

Summary Estonia’s GDP is expected to shrink by 1% in 2008. This is a major

slowdown after having been one of the EU’s fastest growing economies. In our main scenario, we expect GDP to rise by 1.5% in 2009, when the slowdown in domestic demand stabilizes.

Estonia will therefore grow below its potential (which we estimate at around 5.5%) in the years ahead. As a result, the current account deficit and inflation will gradually decrease.

The global financial crisis and poorer economic prospects in Europe will complicate a recovery in the Estonian economy in 2009. A chillier political relationship with Russia could jeopardize growing trade between the two countries.

Consequences for Baltic Sea companies - Weak domestic demand will limit business opportunities for Baltic

companies. Fewer investments in Estonian businesses will mean less demand for machinery and equipment, which account for the large share of the country's imports of goods.

- Labor costs are easing now that demand is lower, despite an underlying shortage of trained manpower. Double-digit nominal wage increases seem unlikely in the next 12-18 months, since the economy will largely stand still.

- We feel that inflation has topped out and a decline can be expected during the forecast period due to weak domestic demand and expectations of lower global commodity prices.

- The timetable for EMU membership could be affected by high inflation. Membership before 2012 seems too optimistic in our opinion. Despite current efforts to reduce price and wage gaps, we expect Estonian prices to increase faster than the EU average in the years ahead.

Estonia


Chillier political relationship with Russia The current three-party government led by Prime Minister Andrus Ansip is facing major challenges now that the slowdown has become more severe than expected. This year's budget negotiations have widened the split within the government, increasing the risk that the coalition won't hold. At the same time, the Estonian government has distanced itself from the Russian invasion in Georgia, which has increased political tension between Estonia and Russia. It could also complicate the integration of the Russian minority in Estonia, which currently accounts for about a quarter of the population.

Estonian economy slams on the brakes The slowdown in the Estonian economy that began in the second half of 2007 has accelerated. GDP dropped 1.1% at an annual rate during the second quarter of this year, the first time the country has experienced negative growth since 1998, in connection with the Russian crisis. The slowdown is mainly being driven by weaker domestic demand – spending and investments. Retail sales have fallen for three consecutive months, and in terms of investments the decline in housing construction is mainly to blame for an overall decrease.

Retail sales in the Baltics, percentage change


03 04 05 06 07 08-10

-5

0

5

10

15

20

25

30Lithuania

Estonia

Latvia

Net exports’ contribution to GDP growth during the first half year is less a reflection of the strength of exports than the substantial decline in imports. This has reduced the current account deficit, which was around 10% of GDP at midyear, against 16% for the full year 2007.

We expect domestic demand to restrict growth throughout the forecast period. GDP is expected to fall by 1% this year before growing a modest 1.5% in 2009. A gradual shift whereby foreign trade contributes more to growth will compensate for modest growth in domestic demand to some extent. As a result, the current account

Lower domestic demand is driving the economic slowdown

A substantial drop in imports improves the current account balance

Estonia


deficit could be further reduced in the year ahead, with less foreign borrowing.

Slower lending growth, higher interest costs, falling housing prices and continued high inflation have made Estonian households more pessimistic. At the same time, we expect the labor market to worsen in upcoming quarters as businesses are forced to improve efficiencies due to rising costs and shrinking profit margins.

The increase in bankruptcies in 2008 – though from a low level – shows that companies are facing tougher economic conditions. Pressure on profit margins will impact employment and wages, while growth in unemployment could be limited by an underlying labor shortage and rising number of workers going abroad. Real wages, which in 2007 grew by over 10%, are expected to remain unchanged or even decline slightly in 2009. The financial constraints faced by households, with falling asset prices, rising lending costs and a lower income trend, are expected to stimulate savings and lead to modest spending growth in 2008 and 2009. This is a significant reversal compared with 2005-2007, a period distinguished by rising debt levels and substantial spending growth.

The country's aggregate gross investment rose by an annual average of 11% in 2005-2007. The investment trend reversed course during the latter part of last year, however, and has since spread to other parts of the economy. Because of shrinking profit margins, as well as higher borrowing costs and reduced growth prospects, private businesses are likely to postpone investment plans. The housing sector, which accounted for a significant share of the increase in investments, is expected to shrink during the forecast period due to falling real estate prices and a housing surplus. Other parts of the private business sector are also likely to hold off investing. Increased public infrastructure expenditures financed through various EU structural funds could have a positive effect on overall investment growth. This applies mainly to roads and rails, as well as improvements in energy consumption.

Expectations that the export sector will take over as a growth engine during the forecast period 2008-2009 could be hurt by the worsening outlook in EU member states in recent months. Since this market accounts for slightly over 70% of exports, there is an increased risk that the recovery in the Estonian economy could be slower than we expected. A continued expansion in Russia and other CIS countries is contributing positively to Estonian exports, though here as well downside growth risks have increased this fall.

Long-term growth issues remain important The possibility of an expansionary fiscal policy is limited even if Estonia’s finances are good compared with many other European countries. The national debt is low (3% of GDP) and government finances are stable. By law the Estonian budget must be balanced or generate a surplus. Last year, the surplus corresponded to 2.8% of

Greater pessimism among households

Increased household savings and lower loan demand

Business investments are being postponed

The global economic slowdown is impacting Estonian exports

Growing demand for spending cuts

Estonia


GDP. The substantial economic downturn jeopardizes the goal of a balanced government budget. Lower tax revenue is increasing the need for spending cuts, which the current coalition government has had difficulty agreeing to in this fall's budget negotiations. It would be sensible, however, if automatic stabilizers were allowed to have their full effect during this slowdown.

Estonia hasn't changed its goal of EMU membership, although the timing has become more uncertain due to the high inflation rate.

Economic policies should be focused more than before on growth issues to eventually stimulate economic development. Helping various markets function more smoothly will increase the chances of lower inflation. Even if the infrastructure for an attractive business climate is in place in many cases, competition for future investments is growing from other low-wage countries. In the World Bank’s latest “Doing Business” report, Estonia still ranks among the countries with the best business climate, despite dropping to 22nd place in this year's survey from 18th last year.

Even though the ranking should be read with caution, it served as a wake-up call for politicians and Estonian business leaders that global competition is growing. Strengthening the export base is one way to reduce long-term imbalances in international trade. Despite that foreign direct investment has increased, a relatively small share – around 14% of the cumulative investment inflow – goes to industrial and competitive sectors. Industrial production is still dominated by low value-added, labor-intensive production. Increased investment in research and development and further product development to raise value-added long-term are therefore important measures.

Jörgen Kennemar

Estonia still offers a positive business climate

Improving value-added is a long-term challenge

Latvia


Latvia – Shifting into reverse Population: 2.3 million GDP per capita 2007: USD 16,890 Government: Conservative coalition Prime Minister: Ivars Godmanis President: Valdis Zatlers Next parliamentary election: October 2010 Next presidential election: June 2011 Average GDP growth in last five years: 9.8% Average inflation rate in last five years: 6.5%

Summary The Latvian economy is expected to shrink in the next two years,

the first time since the early 1990s when it shrank for three consecutive years. We expect GDP to decline by 0.5% this year and another 1% in 2009.

Fiscal policy constraints and lower wage increases are slowing inflation. Less import demand will lower the current account deficit during the forecast period.

Strengthening and developing export industries will be necessary in order to alleviate imbalances in foreign trade. More structural reforms are needed to reduce inflation and avoid delaying EMU membership.

Consequences for Baltic Sea companies - Domestic demand, which previously accounted for the majority of

Latvian GDP growth, will shrink during the forecast period. As a result, the market will generate fewer opportunities for Baltic Sea companies.

- Companies focusing on the retail and housing sectors will be hardest hit by the decline in spending and investments we anticipate in the next 12-18 months, while other companies have better growth prospects.

- Wage growth is expected to decline during the forecast period as demand weakens and Latvian companies rationalize.

- The risk of further energy price hikes is a possibility, which would especially hurt the electricity-dependent industrial sector.

Focus on Russian relationship The relationship with Russia has become chillier since the war in Georgia. This is also complicating the integration of the Russian minority population in Latvia. At the same time, it poses a tricky political balancing act, since Russia is an important market for Latvian companies.

Latvia


Economic slowdown is reducing imbalances GDP growth during the second quarter of this year was only 0.2% at an annual rate, the weakest rate in over nine years. Domestic demand, which has accounted for the large part of the expansion of the last 3-5 years, has declined significantly in 2008. Slower lending growth, falling housing prices and a high rate of inflation have caused a drop in consumer spending. At the same time that retail spending has shrunk for six consecutive months, households are becoming more concerned about the future job market. The declining investment trend that began during the second half of 2007 has accelerated due in no small part to slower housing construction. With exports rising and imports declining, net exports contributed positively to GDP growth. Weak imports have reduced the current account deficit as a percentage of GDP from slightly over 25% of GDP in late 2007 to around 14%, which is considered a positive development.

Current account deficit as % of GDP


Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q100 01 02 03 04 05 06 07 08

-30

-25

-20

-15

-10

-5

0

Lithuania

Latvia

Estonia

Can exports become a growth engine? Uncertainty about Latvia’s future development has increased this fall. Unchanged – or in some cases declining – real wages are anticipated in the year ahead. Private businesses are being forced to rationalize as the economy slows and profit margins stay under pressure. Recent wage data provide further proof that wage growth has peaked and a slowdown is on the horizon.

A weaker global economy and deepening financial crisis is affecting the economy and complicating the financing of the country’s large current account deficit. In EU member states, which buy 75% of Latvian exports, growth is expected to be significantly weaker than assumed last spring. At the same time, payroll costs are rising rapidly – by slightly over 24% in industry – raising questions about the sector’s competitiveness. The appreciation of the Latvian currency in real terms also reduces the possibility of an export-led recovery, since domestic demand is limited by financial constraints and consolidation. We expect GDP to shrink by 0.5% in 2008, compared with an increase of slightly over 10% last year.

The current account deficit is shrinking

Real wages will decline in 2009

Latvia


For 2009 we expect GDP growth to decline by 1%. The biggest risk factor domestically is the expected slowdown in the labor market. Real wages could decline substantially in the year ahead as private businesses see their profit margins come under increasing pressure from weaker demand and rising labor costs. Not until 2010 do we expect growth prospects to improve for Latvia when the international economy recovers and concerns about the global financial market subside.

The recession is increasing the need for growth reform Fiscal policy is limited in the year ahead by shrinking public revenues owing to weak growth. Spending cutbacks are needed, as is a change in priorities, which poses a challenge for the current coalition government. The prospect of a balanced budget seems less likely given current economic conditions, because of which we expect public finances to remain in the red in 2009. Still, from a European perspective Latvia’s government finances remain strong, with a national debt of less than 5% of GDP and a small budget deficit next year.

Communications, construction and the financial sector have been the recipient of the large share of foreign direct investment to date. Far too little of the inflow of investment goes to competitive businesses, which eventually would be detrimental to future export opportunities. Latvia’s central bank also reports that few new investors are entering the market. Improving the business climate must be given greater priority to make the country attractive to more FDI. An analysis of Latvia’s growth also raises questions about the stability of its economic development. Industry’s share of the economy is shrinking and currently represents less than 15% of GDP, the lowest figure in the Baltic countries. The retail sector, on the other hand, has accounted for most of the expansion and comprises nearly 40% of the country’s total production, compared with an EU average of 22%. The economic slowdown during the forecast period could create better understanding of the importance of a strong industrial base, however.

Jörgen Kennemar

Corporate profit margins remain under pressure

More focus on creating an attractive business climate

Lithuania


Lithuania – A softer economic slowdown Population: 3.4 million GDP per capita 2007: USD 17,180 Government: Center/left coalition Prime Minister: Gediminas Kirkilas President: Valdas Adamkus Next parliamentary election: October 2008 Next presidential election: June 2009 Average GDP growth in last five years: 8.4% Average inflation rate in last five years: 2.4%

Summary The global downturn and weaker domestic demand are expected

to slow the economy this year, with GDP growth tailing off even more in 2009. We expect GDP to rise by 5% this year and 3.5% next year.

Slowing economic conditions will reduce slightly the imbalances in the economy during the forecast period 2008-2009, but not to the same extent as in Estonia and Latvia, where the economy is weakening even more.

Opportunities for fiscal stimulus measures are limited. The slowdown is instead forcing politicians to address structural issues.

Future energy supplies and their impact on the economy are a hot button issue. The closing of the Ignalina nuclear power plant could cause significant price hikes.

Consequences for Baltic Sea companies - Domestic demand is not developing as strongly as in recent years,

though it is still growing.

- Inflation is being slowed by weaker domestic demand at the same time that wage increases are declining due to a weaker labor market. Future energy prices are an uncertainty, however.

- A labor shortage will ease during the forecast period as the labor market weakens and the working-age population declines. On the other hand, the flight of workers to other EU member states will subside as the labor market there slows.

Russia and energy dominate the political agenda Political tensions between Lithuania and Russia have risen since late summer not least of all due to Russia’s invasion of South Ossetia and the war in Georgia. The statement that all Russians around the world will be protected regardless of where they live has raised concerns about Russia’s foreign policy. Growing political uncertainty has placed greater focus on defense issues, and some politicians feel that higher defense spending will be needed, especially to reach the goal of 2% of GDP that NATO membership requires. A growing inflow of Russian

Increased political tension between Lithuania and Russia

Lithuania


direct investment to Lithuania has also raised suspicions. Russia is currently the fourth largest foreign direct investor in Lithuania. There are those who are concerned about this, while others believe Russian investment can strengthen the country’s economic development.

Considering today's high energy prices, future energy supplies are becoming an increasingly important political issue in Lithuania. (This generally applies to all the Baltic states.) It will be especially acute in 2010, when the second nuclear reactor in Ignalina is shut down; today it accounts for no less than 70-75% of the country's energy supply. To compensate for the loss, electricity imports will rise substantially, with the risk of higher inflation and slower growth, even if the EU offsets a share of the lost nuclear power through 2012. It also means that Lithuania will be almost totally dependent on Russian natural gas. A new nuclear power plant is planned in cooperation with the other Baltic countries, but it is still uncertain when it would be in place. An electrical cable from Sweden and Poland is also planned, but isn't likely to be ready before 2012.

Lithuania is therefore negotiating with the EU Commission to extend operation of the second reactor to 2012. On October 12, the same day that a parliamentary election will be held, Lithuanians will vote on a referendum to keep Ignalina running. The latest surveys show that nearly two thirds of the population feel the plant should remain open. In October, the EU Commission will reassess the energy situation in Lithuania.

Slower economic conditions in 2009 Growth in the Lithuanian economy has slowed in 2008. To date, it has not been as noticeable as in the two other Baltic states. Preliminarily, GDP in Lithuania rose by 6.2% on an annual basis during the first half year after having grown by 10.8% in the third quarter of 2007. The fact that the slowdown in Lithuania has not been as dramatic could be partly due to its smaller imbalances. At the same time, economic growth rests on a broader geographical base and more growing industries. In the two other Baltic states, growth has been concentrated in metropolitan areas (Tallinn and Riga). Growth in Estonia and Latvia has been more centered on the real estate and retail sectors. These countries are also where tighter credit and falling real estate prices have been most noticeable in the last year.

Darker growth prospects, particularly in Europe, and widespread uncertainty in financial markets suggest that Lithuanian growth will slow further during the forecast period 2008-2009. Weaker domestic demand is the main reason for the expected decline in GDP growth from 5% this year to 3.5% in 2009. The risks are primarily on the downside. The large current account deficit of slightly over 11% of GDP and financing are creating greater uncertainty.

The underlying reason for slower GDP growth is weaker consumer spending, which accounts for slightly over 60% of GDP. Consumer sentiment has become more pessimistic. The combination of falling asset prices, rising interest rates, lower real wages increases and

Energy issues are high on the political agenda

Weaker GDP growth in 2009

Lithuania


tighter lending will keep consumer spending in check in the year ahead. Households are consolidating their balance sheets and saving more after several years of taking on more debt.

Higher borrowing costs in the aftermath of the global financial crisis, shrinking profit margins and slower global economic conditions will limit business investments. This is particularly true in the housing sector. The number of units under construction has fallen substantially in connection with declining housing prices and more expensive mortgages. Public expenditures, financed partly through the EU’s structural funds, are expected to increase greatly, however.

Exports won't provide much of a boost in the year ahead. First, export prospects have declined as the slowdown has become more severe than expected in the EU, a market accounting for slightly over 60% of Lithuania’s total exports. Uncertain economic development in Estonia and Latvia is a concern for Lithuanian businesses, since these countries account for nearly one fifth of its exports. Secondly, the export boom to the CIS countries (Russia, Ukraine, Belarus) is likely to slow due to a weaker global economy and lower commodity prices. Furthermore, political and economic development in Russia and Ukraine has become more uncertain this fall. Thirdly, Lithuanian exports have been limited by shrinking cost advantages in recent years. High wage increases and inadequate productivity growth have impacted the country's competitiveness.

It seems unavoidable that the labor market will weaken during the forecast period, with lower wage growth. Shrinking profit margins and a protracted period of weak growth are forcing Lithuanian companies to reduce labor costs. It is also likely that government salaries will be frozen for budgetary reasons, since tax revenues are expected to decline. The increase in unemployment will be limited, however, by the underlying labor shortage, due to a shrinking working-age population and the large out-migration to other EU member states in previous years.

We believe that inflation has peaked and a decrease can be expected in 2009 in connection with a weaker domestic demand and wage growth. Lower global food and oil prices are also contributing to a slowdown in imported inflation, since they account for slightly over 30% of Lithuania’s consumer price index. Announced electricity price hikes and higher interest expenses will limit the decline in inflation to 5-6% next year, however, compared with slightly over 11% for the full year 2008.

Greater need for reform The Lithuanian government's finances are good. A national debt of around 25% of GDP and public finances that are largely in balance are considerably better than the EMU average. This means that there is room for a fiscal stimulus if macroeconomic development should worsen further. Access to the EU’s structural funds can also soften the economic downturn. Lithuania’s foreign currency policy requires

Housing construction is declining

The export outlook has become more uncertain

A weaker labor market is predicted during the forecast period

The inflation rate is slowing

Room for a fiscal stimulus is limited

Lithuania


fiscal discipline and contributes to confidence in the country's economic policies as a whole.

The currency – litas – is pegged to the euro in a currency board at a rate of 3.45 liras per euro. Joining ERM II in June 2004 as a precursor to the EMU means that monetary policy is basically set by the European Central Bank (ECB). Lithuania’s membership in EMU could be delayed, since it may take time to reduce inflation enough to meet the Maastricht requirements. No official timetable is in place, and it appears that authorities are keeping an eye on overall economic development.

The slowdown is forcing politicians to address structural issues to create better opportunities for sustainable economic development. This could be an important issue for the new government after the parliamentary election in October. The business sector is still dominated by low value-added production. This requires, among other things, increased public investment in research and development, which is currently far below the EU average of 2% of GDP. Lithuania has the opportunity to benefit from the EU’s extensive structural funds. Lithuania’s attraction as an investment for foreign players is reflected in the inflow of direct investment to industry. Among the Baltic countries, Lithuania receives the most industrial investment, which eventually could improve its foreign trade imbalance.

Jörgen Kennemar

EMU membership will be delayed

Poland


Poland – Faster pace of reform Population: 38 million GDP per capita 2007: USD 15,330 Government: Liberal conservative Prime Minister: Donald Tusk President: Lech Kaczynski Next presidential election: 2010 Average GDP growth in last five years: 5.1% Average inflation rate in last five years: 2.0%

Summary Poland is also affected by the weaker global economy and lower

credit growth. GDP will grow by a respectable 5.3% this year and 4.6% in 2009.

Domestic demand continues to develop strongly, while the export sector is slowing. The current account deficit is rising, but is financed primarily by foreign direct investment.

In terms of economic policy, Poland’s government is focusing on meeting the publicly announced timetable for EMU membership. Inflation exceeds the national target, but will gradually decline so that the target is reached in 2010. The goal is to participate in ERM II by next year and then reach full membership in EMU in 2012.

Consequences for Baltic Sea companies - Continued strong growth in consumer spending and investments is

creating good opportunities for companies throughout the Baltic Sea region. Investments are still driven to some extent by Poland's EU membership, in addition to infrastructure investments.

- Poland’s increasingly tight labor market is contributing to high wage growth and rising labor costs. Earnings are declining, since productivity is not growing as quickly. To remain competitive will require efficiency improvements and measures to raise productivity.

- Workers returning home to Poland from the UK, for example, may reduce bottlenecks, mainly in construction.

- Interest rates could rise further before rate cuts are needed, probably not until next year.

- The zloty has appreciated 12% against the euro in the last year (and by 16% against the Swedish krona). Long-term, the currency still faces underlying upward pressure, but if the zloty participates in ERM II next year we are likely to see a narrower range, which will increase stability vis-à-vis the euro.

Poland


- Energy prices could rise in the years ahead, partly because the market is pushing up prices and partly because of the trade in carbon offsets, which particularly affects Poland.

- Poland maintains good access to foreign direct investment, which is positive considering that its rising current account deficit must be financed. It also helps to modernize the business sector by adding new competence and new ideas. Poland’s renewed efforts regarding privatizations will contribute to even greater direct investment in the years ahead.

Growing challenges for Poland’s popular government In October of last year, the Poles elected a new government. The relatively young center-right prime minister, Donald Tusk, from Civic Platform (PO), governs together with the Polish People's Party (PSL), which is led by Jaroslaw Kaczynski. His twin brother, Lech Kaczynski, from the opposition Law and Justice Party, remains president.

The new government is seen as EU- and business-friendly. It is popular both at home (especially among young people) and abroad. Poland’s Minister of Foreign Affairs, Radek Sikorski, has improved Poland’s tarnished reputation in the EU after the Kaczynski brothers’ erratic behavior.

The previous government’s policies, the expanding economy and the absence of serious opposition have contributed to this popularity. If an election were held now, 48% would vote for the current government, while the opposition has the support of 28% of voters. During the last year, the government has tried to reduce bureaucracy. It has also shaped economic policy with future EMU membership in mind.

The conflict between Russia and Georgia probably pushed Poland to hurriedly sign an agreement on August 14 with the U.S. to place missiles on Polish territory in exchange for American military support.

During the remainder of its term, the PO will probably have a harder time governing. The economic outlook isn’t as bright. The PSL is expected to make greater demands within the coalition, and Poland may not be able to maintain its majority government. The PO has hopes of winning the presidential election in 2010, because of which Polish politics are becoming less radical.

The government’s reform policies include the privatization of nearly 700 companies in the next four years. Of Poland’s 10 largest corporations, six are state-owned and the other four are partly owned by foreign multinationals. Poland is still behind other new EU member states in terms of privatizations, but is now expected to increase the pace if the financial crisis does not create problems. There is resistance to selling companies in energy and raw materials. Several utilities will be sold, but companies in oil, coal and copper are likely to be retained by the state.

Poland now has a more business- and EU-friendly government

The presidential election in 2010 is affecting current politics

The privatization process is being speeded up

Poland


Polish authorities are worried about the EU Commission’s plan to reduce CO2 emissions by 20% in the EU. For every megawatt of electricity it produces, Poland emits 0.94 tons of CO2 into the atmosphere. The corresponding figure in Sweden is 0.02 tons. Poland, which uses coal, is forced to buy more carbon offsets, which raises the price of electricity much more than the 22% average for the EU. Price hikes will impact growth and employment, but at the same time are creating the incentive to develop cleaner electricity.

The government must also deal with the EU Commission’s accusations that three Polish shipyards have received state subsidies, which are illegal. If they have to pay them back, these shipyards are expected to file for bankruptcy, since none of them have produced a profit in years. Fifteen thousand jobs are potentially in jeopardy. The Poles are nostalgic about shipyards, which was where the labor union Solidarity took up the fight against communism.

Another challenge is to improve infrastructure. Poland’s railroads and highways are underdeveloped, and the weak infrastructure even affects its neighbors’ development. Together with Ukraine, Poland is planning to host the 2012 European Football Championship, which will require extensive investments in roads and arenas.

The economy – Poland shifts into lower gear Poland’s economy has grown strongly for ten consecutive quarters, and GDP growth has exceeded 5%. This year growth has declined marginally, from 6.3% in the first quarter to 6% in the second. A major investment boom is under way in the aftermath of Poland's EU membership. At the same time, consumer spending is growing due to a strong labor market, higher real wages, tax cuts and credit growth. Unemployment was nearly 18% in 2005, but is now slightly over 9%.

Growth in the labor market is also causing bottlenecks. When the labor market becomes tight, wages rise quickly, currently faster than productivity is growing. This increases expenses for companies hurts them competitively.

Nearly one million Poles work abroad, many in the UK. The supply of work at home is low, especially for those who are older, though young people are also having a hard time getting a foothold in the job market. Unemployment among the young was 21.7% (compared with Sweden’s equally high 19.1%).

Polish industry is also feeling the effects of the slowdown around the world. The Polish purchasing managers index is now 45.8 (August), far below the growth zone. Due to continued high growth in domestic demand, the stronger zloty and a slowdown in exports orders, the current account deficit is now rising due to a worsening trade balance. In addition, the British pound has weakened and Polish migrant workers are therefore sending less money home, adversely affecting the balance of transfers, which is also part of the current account balance. We expect the deficit to exceed 5% of GDP next year.

Major infrastructure investments are on the agenda

Poland


What are Poland’s economic prospects? They are still fairly good. Poland is shifting into lower gear, but it's probably going from 4th to 3rd.

Poland is affected by the global slowdown but has strong domestic demand thanks to rising real wages and relatively high investment needs. As a result, it will continue to grow faster than more mature EU member states. We expect GDP to grow by 5.3% this year and 4.6% in 2009 (against 6.6% last year).

The Polish financial sector is handling the current financial crisis fairly well. The price of credit default swaps has risen, but not more than in many other new EU member states. The country’s financial institutions are considered robust and have little exposure to the structured securities market.

On the other hand, credit growth is slowing, which is gradually affecting growth in the real economy. To date, this is most evident in the household sector, while lending to the corporate sector is growing unabated. Expectations of an appreciating currency could encourage borrowers to seek loans in foreign currency. Although this has become more common, foreign loans still account for only 25-30% of total borrowing (against 70-75% in Estonia and Latvia).

Economic policy is tightening. The Polish central bank has raised its key interest rate four times this year to 6% (it was 4% in the spring of 2007). The government also plans a less expansive fiscal policy. The economy is no longer getting a boost from economic policy.

Economic policy is in order Like many other countries, Poland is struggling with high inflation. Higher food and energy prices are the main reason why consumer prices rose by 4.8% in August. The stronger zloty has limited the price rise slightly, however. On the other hand, high wage growth (double-digit) is keeping pressure on business costs. Many companies have seen their profits shrink, and there is a risk that these higher expenses will increasingly be passed on to the consumer. The Polish central bank’s inflation target is 2.5%, with a tolerance interval of one percentage point. This target will not be reached during the forecast period.

The government is trying to meet the Maastricht criteria so that the country can join the EMU. As a result, further interest rate hikes remain a possibility, but considering the prospect of a weaker global economy and lower commodity prices there is unlikely to be more than one more hike this year. The high inflation rate is near the limit of what would be acceptable had Poland been ready to join the EMU today. The budget deficit is less than 3%, but the government wants to reduce it to at least 2% of GDP to have a better margin.

Inflation will exceed the central bank’s target in 2008-2009

Reform policies are affected by the desire to join the EMU

Poland


The government has now announced its plans for EMU membership. Next year, Poland is expected to participate in ERM II. It then needs two years during which the zloty will be allowed to fluctuate by no more than 15% within a predetermined range against the euro. The most likely scenario – assuming it adheres to the timetable – is that Poland becomes a member in 2012.

Participation in ERM II creates risks. Since the zloty is widely traded on foreign exchange markets, there is a greater chance of speculative attacks, compared with Slovenia’s and Slovakia’s participation. It is a key, therefore, that financial markets have confidence in Poland’s economic policies and that it becomes a member of the EMU. Otherwise the period in ERM II could destabilize the economy.

There are other questions as well. Is a constitutional amendment needed, since by law the Polish central bank governs monetary policy? Will a national referendum be held on the euro, e.g., at the same time as the presidential election in 2010? There is also a question whether economic conditions and the financial crisis will affect the timetable. The most important thing is that Poland doesn’t rush into EMU and takes its time to make sure that there is a good chance its membership is accepted.

Another challenge for the economic policy is to increase the labor supply. The employment level is currently no higher than 50%. A little help could come from the many workers who return home after working abroad. Other measures could include changes to early retirement benefits and a reform of the farmers’ pension system. Furthermore, Poland – like other countries in the Baltic Sea region – must continue to raise productivity by investing in research and development and improving infrastructure.

Cecilia Hermansson

ERM II participation will require confidence in Poland’s policies

Major challenges remain in the labor market

Germany


Germany – Trying to stay above water Population: 82.3 million GDP per capita 2007: USD 33,530 Government: Grand coalition CDU/CSU/SPD Prime Minister: Angela Merkel President: Horst Köhler Next parliamentary election: September 2009 Average GDP growth in last five years: 1.4% Average inflation rate in last five years: 1.8%

Summary The German economy has slowed substantially, and several

indicators point to weak growth in upcoming quarters. GDP is expected to grow by 1.8% this year, but only reach 0.6% next year.

Even though Germany doesn’t suffer from a housing bubble or external imbalances, it has still been infected through worsening export prospects. Investments are slowing at the same time that consumer spending has stagnated despite a stronger labor market.

Consequences for Baltic Sea companies - Domestic demand will develop weakly in 2008-2009, though in

terms of volume this is a large market with a middle class that is still spending. It is by no means an unattractive market to gain share and thereby boost revenue.

- Unit labor costs have fallen in real terms by approximately 1.5% annually in the last two years, but now are stabilizing. German exporters are also cutting back due to weaker global demand. Germany competes mainly on the basis of quality and has therefore remained competitive.

- Household and business confidence has fallen markedly. Consumers have a high rate of savings at slightly over 10% of disposable income. They shouldn't feel so anxious, but high inflation, rising borrowing costs and a less favorable labor market are making them pessimistic.

- Wage increases have been modest despite the growing economy. Now that growth has slackened, there is no longer the same concern for a wage and price spiral, which is sure to draw the attention of the ECB. The demand of the powerful IG Metall union for an 8% wage hike is meeting resistance and is likely to be cut in half.

Politics, economics and structures Although parliamentary elections are not scheduled for another year, Germany is already being swept up by election fever. Upcoming state

Germany


elections are clearing the way for new players. The Social Democrats, SPD, are seen as two separate parties under one roof. Since the previous chancellor, Gerhard Schröder, failed to help the unemployed, a left-leaning group has criticized the party’s politics.

On September 7, Frank-Walter Steinmeier was nominated as the party's candidate for chancellor, succeeding Kurt Beck, who hastily stepped down as chairman. Steinmeier was the one who designed the reform policies under Schröder. He is also certainly the country's second most popular politician after Chancellor Angela Merkel.

The coalition between SPD and Ms. Merkel’s sister parties, CDU and CSU (Christian Democratic Union/Christian Social Union), is still holding. Merkel’s pragmatism is probably one reason why. Her party currently has the support of nearly 40% of the electorate, according to opinion polls, while the SPD has fallen to 20%. The Left Party is the country's third largest, with the support of 15% of voters.

There is a risk that the year ahead will involve more “campaigning” than “governing.” For the two political blocs, the emphasis is likely to be on setting themselves apart and gaining a big enough majority in the next election to avoid a coalition.

What are the most important election issues? “It’s all about the economy, stupid,” also applies to Germany these days. Though it doesn’t have a housing bubble and has large savings in the household sector, along with a current account surplus and relatively solid government finances, the country is affected by the excesses of its friends, the Americans, and many Germans feel this is grossly unfair.

On the other hand, Germany has benefited from the economic boom of recent years as the world's largest exporter of goods (a position it may still retain this year before China takes over). Now that the global economy is no longer growing at the same pace, Germany is also slowing down. The question is whether a recession is imminent, as some experts predict. Chances are that the country will manage to stay just above water.

The first quarter this year looked positive. GDP grew by 1.3% compared with the previous quarter, after which there was an abrupt drop to 0.5%. Investments are slowing, especially in the construction sector, which got a big boost in the first quarter from unusually warm weather. Net exports were positive, but that was only because imports fell more than exports.

To date, the significant decline in unemployment and rising real incomes have not caused Germans to increase their spending markedly. High inflation is serving as an obstacle, as is weak consumer confidence.

Germany has managed to remain competitive in recent years – admirably so – by improving productivity and keeping wage increases in check, but that won't help now that the rest of the world is slowing

Campaigning is now taking precedence over governing

Germany has benefited from the U.S. boom through exports

Households haven't opened their wallets – despite the labor market

Germany


down. Export orders are falling and prospects are worsening. Corporate investment is also hurt by weaker credit growth; German investment banks have been impacted by the subprime crisis as well. On the other hand, conditions aren't right for a speedier consolidation of the German banking market. Fragmentation will continue and will be reduced slowly.

In the year ahead, the debate on taxes will arise once again. To cut or not to cut, that is the question. The CDU is more anxious to get something done than the SPD. Whether the 2011 budget can be balanced is being called more into question. Germans don't have a high tax ratio (36% of GDP), but the “mittelstand” still feels it is being harshly taxed. Those clamoring for tax cuts now face more questions: Will the economy allow them? Will expenditures grow more than planned, not least because of the pension system, higher wages in the public sector and higher health care expenditures? It's also important not to neglect areas that will impact Germany's long-term competitive strength: R&D, education and infrastructure. In other words, the same issues that are on the political agenda of every other Baltic Sea country.

Cecilia Hermansson

Many Germans want lower taxes, but the question is whether the economy can handle them right now

Denmark


Denmark – The housing market is cooling the economy Population: 5.5 million GDP per capita 2007: USD 36,300 Government: Liberal–Conservative coalition Prime Minister: Anders Fogh Rasmussen Next parliamentary election: by 2011 Average GDP growth in last five years: 2.2% Average inflation rate in last five years: 1.7%

Summary Denmark's economy is facing several weak years ahead. We

expect GDP growth to reach 1% this year, but that's likely to be cut in half in 2009.

The fundamentals are good in terms of government finances, the corporate sector and the current account balance. On the other hand, the credit and housing markets have expanded a little too quickly in recent years, and a correction is hurting asset values, which in turn is affecting domestic demand. In addition, the export sector is cooling off due to the global economic slowdown.

Consequences for Baltic Sea companies - Companies active in the Danish market can expect several years

seen in slow motion ahead, though this will provide new opportunities to capture market share.

- Consumer confidence is very negative at this point, but lower inflation and a calmer financial market could improve sentiment. An opportunity exists to introduce a more expansionary fiscal policy to ease the economic slowdown.

- From a long-term perspective, Denmark is an attractive market in terms of both production and demand. Infrastructure investments to link Denmark and Germany could have a significant effect on growth nationally and for the business sector.

- Denmark invests heavily in environmental technology and renewable energy. There are opportunities for alliances here for companies from other countries to further strengthen the sector throughout the Baltic Sea region.

Politics, economics and structures In last year's Baltic Sea Report, we wrote that it was time to fasten your seatbelt because Denmark was about to land. The only question was whether it would be hard or soft. Last year, the economy grew by 1.7%, but this year and next we expect significantly weaker GDP

Denmark


growth. A hard landing isn't to be expected, however, considering that the labor market has remained fairly stable.

The real estate market is cooling the economy. Sales are taking longer and prices have fallen (by approx. 5% for apartments and slightly less for single-family homes). The housing market hasn't dropped to the same extent as it did in the early 1990s. Consumer confidence, on the other hand, has. High inflation, rising interest rates and concerns about the financial crisis and global economy may be having an impact. We don't expect spending to decline, but we do see weak growth this year and next.

The government’s fiscal policy could make a difference. The surplus in public finances is high, and the second stage of last year's tax package is expected in 2009. Lower inflation and calmer financial markets could encourage the Danish central bank to cut interest rates to the ECB level. The key interest rate is currently 4.6%, against the ECB’s 4.25%, an unusually large difference. The difference in long-term interest rates vis-à-vis Germany has also risen as a result of the credit crisis and turbulence in the Danish banking system.

The investment climate is also affected by the slowing real estate market, since housing investments are on the decline. At the same time, there is a risk that other investments will slow, since the financial crisis is reducing credit growth and increasing funding costs. Weaker export growth would also seem to indicate that companies have sufficient capacity under current economic conditions, which could delay further investment.

How serious is the Danish situation? The financial and real estate markets are feeling the effects of the turbulence. On the other hand, Denmark’s public finances are stable and it has a low national debt, a current account surplus, low employment and job growth. Wages are increasing faster than desirable from a competitive perspective, though this is positive from the standpoint of households and spending. Inflation is following many other countries and a decline is expected.

Denmark is headed for a landing, and though it may be hard, don't expect a crash.

Cecilia Hermansson

Lower housing prices are slowing growth in spending and investments

Denmark has sound government finances and good fundamentals

Finland


Finland – Shrinking exports Population: 5.3 million GDP per capita 2005: USD 34,550 Government: Coalition between Center Party

and Social Democrats Prime Minister: Matti Vanhanen President: Tarja Halonen Next parliamentary election: 2011 Next presidential election: 2012 Average GDP growth in last five years: 3.5% Average inflation rate in last five years: 1.0%

Summary Finland’s GDP growth has been cut to less than half this year,

according to our projection, and will reach 2%, against 4.5% last year. A weaker export outlook and more cautious spending and investments will reduce growth further to 1.2% in 2009.

Emerging economies are increasingly important to Finnish exports. If they were to slow more than expected, Finland would feel it in the form of even weaker growth prospects. Russia in particular is a wild card, generating risks on both the upside and downside.

Consequences for Baltic Sea companies - Domestic demand is slowing, but tax cuts are softening the

recession somewhat. Despite the cuts, and a slowing economy, Finland’s public finances are in good shape.

- Inflation has peaked, and lower energy and food prices will lead to lower price increases going forward.

- Finland has been facing a labor shortage, but this problem should diminish as the economy slows. In addition, wage pressure is easing as unemployment rises.

Politics, economics and structures During the last two years, the Finnish economy has grown by over 4% on average, driven by strong consumer spending and high investment growth. Exports have also developed strongly, particularly to Russia and China, which accounts for a growing share of Finnish exports. The economy has slowed in 2008 as global conditions have weakened. Exports have dropped. Because of rising interest rates and higher inflation, spending and investments have not grown at the same rate as earlier. GDP rose by 2.4% on an annual basis during the first half year, clearly slower than the second half of last year.

A weaker global growth outlook and continued uncertainty in financial markets are also affecting the Finnish economy. Still, it remains basically robust, with large surpluses in its public finances and current

Finland


account balance. The risk of a major slowdown increased this fall, however.

We expect GDP to rise by 2% this year and 1.2% in 2009. Weaker demand in EU member states and emerging economies will further hamper Finnish exports. Higher unit labor costs during the forecast period will also hurt business competitiveness.

The worsening financial crisis has led to a slower credit growth and higher funding costs. Tighter financial terms and weaker global economic conditions are forcing companies to delay investment plans. Housing construction has already begun to decline due to higher interest rates and construction costs.

Consumer sentiment has declined significantly in 2008. Rising interest expenses, high inflation and falling asset prices have increased pessimism. In addition, the labor market is slowing, also affecting household income and purchases.

Jörgen Kennemar

Norway


Norway – Slowing, but is still the fastest growing Nordic country Population: 4.7 million GDP per capita 2007: USD 53,320 Government: Coalition between Labour, Socialist Left and Center parties Prime Minister: Jens Stoltenberg Next parliamentary election: September 2009 Average GDP growth in last five years: 2.7% Average inflation rate in last five years: 1.5%

Summary Norway is undergoing a correction in its financial and real estate

markets, which will slow GDP growth to 2.5% this year and 1.7% in 2009. Higher investments in the oil sector are offsetting part of the slowdown in the household sector.

The labor market will remain an important factor in determining the extent of Norway’s economic slowdown. We expect a modest slowdown, which will lead to lower, though still high, wage increases.

Consequences for Baltic Sea companies - With a huge budget surplus and substantial current account

surplus, Norway still stands strong in a weaker global economy. Households have adjusted their balance sheets and are saving more, which will impact spending growth. Domestic demand is rising, but not as strongly as before.

- For companies with production in Norway, the rise in labor costs will slow slightly.

- Assuming that the Norwegian central bank keeps its key interest rate higher than competing countries for slightly longer, it should push up the krone. Oil prices, on the other hand, will be a wild card for the currency.

Politics, economics and structures Last year the Norwegian economy grew by 2.6% (2.9% for the mainland economy) after several years of good economic development. Norway stands apart from the rest of the Nordic region thanks to its huge oil reserves. High oil prices have helped to raise investments in oil companies. This trickles down to other companies, including the service sector, though it will be hard to keep up with the previously high rate of investment.

Norway


High inflation and interest rates are hurting the economy. Households have become more cautious and less confident in the future. A cooling real estate market also means less spending and investments. Spending growth has slowed from 6% in 2007 to 2% at present, though this is still higher than many other Western European countries.

Norway’s labor market is still tight, and unemployment is expected to rise modestly. As a result, wages will continue to increase, though not as substantially as in recent years.

Since 2009 is an election year, more expansionary fiscal policy is certainly a possibility. Demands that the government ease the pain of the economic slowdown for households will increase. Discussions are already being held whether to increase spending on healthcare, education and social services. However, the Norwegian oil fund has been affected by the global financial crisis and lost value as a result. Though less is money available, an election year is still an election year.

Gradually rising interest rates in the last three years (in the summer of 2005 the key policy rate was 1.75%, against 5.75% today) have not been enough to slow escalating inflation. In August, inflation was 4.5% on annual basis, a dramatic change from a year ago, when prices were falling. While food and energy prices are largely to blame, high wage increases are also a factor to keep an eye on. The central bank will probably wait (until the second half of 2009) before beginning to cut rates.

In our main scenario, we expect relatively good economic development to continue in Norway, although risks have become more complex. Slowing global demand is lowering oil prices, thereby affecting the krone, inflation and growth. At the same time, the Norwegian financial and real estate markets are undergoing a correction and households are adjusting their balance sheets. How far this goes will depend on the labor market – both employment and wages. Considering the tight job market, we expect Norway to handle this adjustment without a major impact on the economy. GDP will grow by 2.5% this year and 1.7% next year.

Cecilia Hermansson

GDP will get a boost from oil investments, but households are cutting back

An election year suggests higher public spending

Later next year, the Norwegian central bank is expected to begin cutting rates

Sweden


Sweden – Decelerating more than expected Population: 9.1 million GDP per capita 2007: USD 36,590 Government: Moderate coalition Prime Minister: Fredrik Reinfeldt Next parliamentary election: September 2010 Average GDP growth in last five years: 3.3% Average inflation rate in last five years: 1.3%

Summary Weaker global economic conditions and a protracted financial

crisis are hurting future confidence and the export outlook for Swedish companies. Sweden’s GDP is expected to grow by 1.5% this year and 1.2% next year, revised downward from the August forecast by 0.3 and 0.5 percentage points, respectively.

At the same time, commodity prices have fallen or stabilized, which is slowing inflation. Inflation expectations have moderated and the central bank has the opportunity to cut interest rates more than we expected in August. Sweden is in strong financial position and can therefore maintain an expansive fiscal policy, softening the impact of the economic slowdown.

Consequences for Baltic Sea companies - In our main scenario, we see prospects of a slow global and

Swedish recovery in 2010. This projection contains large, and complex, risks, however. Companies can expect at least two years with low growth during which domestic demand and exports underperform.

- Pressure to increase wages is expected to be lower and productivity higher. Unit labor costs are also being positively affected by lower social security contributions. This will finally break the spiraling cost pressures on companies.

- An extended labor shortage is now easing as the job market weakens. There will still be sectors where a shortage of specialists or other employees is noticeable, however.

- There are major differences in how businesses are affected by the slowdown. The Swedish auto industry has weakened due to the economy and structural changes (climate, environmental, demand for fewer cars, etc.). Companies specializing in input and capital goods are seeing solid demand, especially from emerging economies. Parts of the service sector continue to develop strongly.

Sweden


Politics, economics and structures Since the August forecast, global growth has been revised downward, as have assumptions about oil prices. Lower GDP growth, mainly in Europe, and increased financial turbulence are also necessitating revisions in the economic outlook. At the same time, inflationary pressures are easing, which is positive for interest rates.

We predicted in April that the market for Swedish export companies would grow by 5% this year and 4.5% next year. Lower demand is slowing international trade even more. As a result, market growth will fall to 4.5% this year and 3.5% in 2009, owing to which Swedish exports will develop weakly. Sweden, which usually has a hard time competing in a slowing market, will lose market share next year, because of which export growth will only reach 3%.

Import growth has also slowed compared with our August forecast. Still, imports are not declining as much as exports, and net exports are therefore expected to have more of a negative effect on GDP growth next year.

In addition to weaker market growth, the Swedish economy is being affected by lower confidence among businesses and households. Consumer pessimism is expected to reduce spending growth and raise the savings ratio. In times of financial crisis, people try to save more. They also try to reduce their debts when interest rates rise. Household spending will fall 1.8% this year and 1.5% next year.

The labor market is weakening further, another factor affecting consumers’ buying plans. The latest indications are that companies will have to rationalize more than previously expected. The total labor force will continue to rise for the year as a whole, but then decline 1% next year (in contrast to our August forecast of 0.5%). Unemployment will rise to 7.4% next year, from 6.2% in 2007 and 6.5% this year.

In 2007 and most of 2008, productivity has fallen in the Swedish economy as more people, including many with little work experience, have joined the labor force. In 2009, we expect productivity to again rise (to 2.3%), when the number of hours worked begins to retreat. When the hours worked declines, so does disposable income. On the other hand, we have assumed in our new forecast that inflation will fall faster toward the targeted level. Taken together, this means that disposable income should remain unchanged in real terms, compared with our previous forecast.

Many companies have been operating at high capacity, and the need for investments was previously considered relatively modest. A worsening financial crisis, tighter credit and higher payroll costs are slowing demand for and supply of credit. Investments are rising more slowly as businesses postpone them until the uncertainty is alleviated. As in our previous forecast, we expect housing investments to shrink next year, and activity in the real estate market will be lower due to the financial crisis and weaker economic development.

Weaker global trade is slowing exports

Confidence in the future is also weaker and is affecting consumption and investments

Unemployment will rise to 7.4% next year

Productivity rises when hours worked declines

Sweden


The Swedish government has presented a budget containing a fiscal stimulus package corresponding to 1% of GDP. Household income is improving and public investments are affected positively. Labor costs are dropping slightly, and lower corporate taxes are also having a positive effect. These factors are already discounted in our forecast. By 2010 – an election year – further measures are likely to strengthen the country competitively in the long term and, most importantly, to give the Swedish labor market a boost by the fall.

Sweden has good fundamentals. The government is operating at a surplus, although it is shrinking and probably will be erased in 2010. National debt is low from a historical perspective. The current account surplus is also high. Swedish companies are well prepared after a period of solid earnings growth and relatively sound balance sheets.

Swedish households have increased their debt to historically high levels, however. Housing prices have risen due to low interest rates. Household sector balance sheets will be adjusted during the forecast period now that conditions have changed. We are not expecting a major correction, however. Even if housing prices fall slightly, the labor market would have to deteriorate much more than we predict for the economic outlook to worsen significantly.

Inflation according to CPI and CPIX (underlying inflation), annual rate

GDP is now expected by grow by 1.5% this year and 1.2% next year (actual GDP – calendar-adjusted growth would be 1.2% this year and 1.4% in 2009).

At the same time, we anticipate a lower inflation rate than in our August forecast. This year, inflation, as measured by the CPI, is projected at 3.7% and next year 2.3%. In one year, we expect consumer prices to rise by 1.5%, compared with the current rate of 4.5%.

This will allow the Riksbank to cut its key interest rate, which we expect to fall to 3.5% by the end of next year (compared with our August forecast of 4%). We see the Swedish krona rising in value against the euro but weakening against the dollar.

Cecilia Hermansson

Fiscal policy may ease the slowdown slightly

Swedish households can’t neglect their historically high debt ratios

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Sweden forecast


Swedbank’s economic forecast for Sweden September 2008

Supply balance sheet

Change in volume (%) 2006 2007 2008P1) 2009P1) Consumer spending 2.5 3.0 1.8 (2.1) 1.5 (1.7) Public spending 1.5 1.1 0.8 (0.8) 1.2 (1.2) Fixed gross expenditures 7.7 8.0 3.7 (4.0) 2.5 (3.1) - Businesses excl. housing 6.6 8.4 3.9 (4.2) 2.6 (3.4) - Public agencies 7.1 3.3 5.8 (5.8) 8.0 (8.0) - Housing 13.8 8.7 1.2 (1.5) -3.0 (-3.0) Inventory investments 2) 0.2 0.7 -0.2 (-0.2) 0.0 (0.0) Exports, goods and services 8.9 6.0 4.5 (5.0) 3.0 (4.0) Imports, goods and services 8.2 9.6 5.5 (5.7) 4.2 (4.7) GDP 4.1 2.7 1.5 (1.8) 1.2 (1.7) GDP, calendar-adjusted 4.4 2.9 1.2 (1.5) 1.4 (1.9) Domestic usage 3.0 3.2 1.7 (1.9) 1.5 (1.7) Net exports 1.0 -1.1 0.0 (0.1) -0.3 (0.0) 1) The figures from our latest forecast in August 2008 are in parentheses 2) Percentage change in previous year’s GDP

Key ratios

Annual percentage change unless indicated otherwise 2006 2007P 2008P 2009P Nominal hourly wages, total 3.2 3.6 4.0 3.8 Nominal hourly wages, industry 3.2 3.9 3.4 3.6 Industrial production 5.1 2.7 1.6 1.2 CPI, annual average 1.4 2.2 3.7 2.3 CPI, Dec-Dec 1.6 3.5 3.4 2.3 CPIX, annual average 1.2 1.2 2.7 2.2 CPIX, Dec-Dec 1.2 2.0 2.6 1.9 Real disposable income 2.8 4.3 2.2 1.5 Savings ratio 7.1 8.3 8.7 8.7 Open unemployment 3) 7.0 6.2 6.5 7.4 Total unemployment 3) 4) 10.0 8.1 8.4 9.4 Total labor force 1.9 2.4 0.8 -1.0 Current account balance 5) 8.5 8.4 7.8 7.5 Financial savings in public 2.2 3.5 2.5 0.9 sector 5) National debt (Maastricht) 5) 45.9 40.6 35.5 32.0 3) Percent of labor force, EU-harmonized 4) Open unemployment and labor market measures (individuals aged 16-64) 5) Percentage of GDP

Economy & Finance

Baltic Sea Report September 2008