Baltic Solutions for the Adriatic

April 10, 2013 • Commentary
This article appeared in Financial Times on April 10, 2013.

Slovenia, once celebrated as the poster boy of central and eastern Europe, is now widely perceived as yet another sick man of the eurozone. With bond yields close to those of Portugal and a Moody’s downgrade for one of the country’s largest banks, rumors of an imminent bailout abound — though vehemently denied by Alenka Bratušek, Slovenia’s prime minister.

To solve their problems, Slovenians should look north, as their woes resemble the afflictions facing the Baltic states only four years ago.

Make no mistake — Slovenia is not a basket case. Since the collapse of Yugoslavia, the country has boasted a strong and innovative private sector, superb infrastructure, alpine vistas and manicured lawns, making it look more like Austria or Switzerland than a transitional economy.

In spite of a harsh economic contraction of almost 8 per cent in 2009 and only a weak recovery since, Slovenians remain the most affluent among the denizens of transitional countries of central and eastern Europe, with unemployment still below 10 per cent — much less than the 14.5 per cent in Slovakia, generally perceived as a country that has weathered the crisis successfully. Slovenia’s debt to GDP ratio is hovering at roughly 53 per cent of GDP — by European standards an eminently reasonable number.

Moreover, Slovenia’s troubles are neither unprecedented nor impossible to fix. Unsurprisingly, the key lies in the country’s banking sector, which includes some €7bn in bad loans, around 20 per cent of the tiny Adriatic nation’s GDP. The financial meltdown in Cyprus has shed doubts on the ability of Slovenian banks to deal with the problem and, for that matter, on the ability of the Slovenian government to recapitalize its banking sector, should the need arise.

This is why Slovenia should look north. During its lending boom between 2000 and 2007, Latvia’s indebtedness reached 116 per cent of GDP. At the onset of the crisis in 2008, bad loans in Lithuania and Latvia were roughly one fifth of total loans. And as in Slovenia’s case, which has been a member of the eurozone since 2007, Latvia’s excessive private debt has been partly fueled by a fixed exchange rate regime.

In 2008 and 2009 Latvia, alongside other Baltic states, suffered a deep economic contraction. To a large extent, the Baltic states, including Latvia, reacting similarly, deploying a combination of severe spending cuts and far‐​reaching structural reforms, and quickly rebounded. The size of the fiscal adjustment was staggering — in Latvia alone it was equal to over 11 per cent of GDP in just one year.

Among the measures taken by the Latvian government were reforms that improved legal mechanisms for credit enforcement, encouraging decentralised debt resolution through markets, and also changes to the tax code which facilitated debt write‐​downs. In the financial sector, the results were not immediate — the proportion of non‐​performing loans would remain high for several years.

However, as Slovenian leaders should note, the overall economic effect of Baltic reforms was quick and unambiguously positive. Since 2011, growth rates in the Baltics have been consistently above 5 per cent, in the midst of global financial and economic turmoil.

Although Latvia was a recipient of an IMF loan, it is far from obvious that aid made a huge difference — after all, Lithuania and Estonia, which did not receive IMF aid, followed similar reform strategies with very similar outcomes. Given the low level of public debt, there is no reason why a credible reform strategy on the part of a Slovenian leader should not elicit trust on the bond markets.

Bratušek should reflect carefully on the story of the Baltics before making any irreversible moves. Although European leaders have tried a spectrum of shenanigans to avoid such conclusions, the truth is that in economic adversity, there is no substitute for sound policies and far‐​reaching, pro‐​growth reforms. And while some pain is unavoidable, the Adriatic nation of 2m people now has a unique opportunity to join Estonia, Latvia and Lithuania as a pioneer of economic reforms that can lead Europe’s way out of the present mess.

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