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Macro analysis - April 22, 2014

The Russia-Ukraine conflict: Impact on the Baltics

Russia is structurally too weak to generate growth, but has quite large reserves to withstand moderate sanctions from the West for an extended period. It will be a drawn-out, volatile, and economically costly conflict, whichever scenario plays out. The negative impact on the Baltic economies will mainly feed through less foreign trade and investment by companies trading with Russia and its closely related countries, but this negative impact would be amplified if general household and business confidence in the Baltics were hit significantly. If the Russia-Ukraine conflict does not escalate further and sanctions remain at about the current level, the Baltics will continue to grow, but slower than previously forecast. If the conflict worsens, the risks of recession increase. by sluggish global growth and a trend decline in oil prices. The lack of structural reforms (e.g., improving the rule of law and efficiency of state-owned-companies, and reducing corruption) will discourage investment and, thus, productivity growth. Capital outflows and an interest rate increase driven by the Russia-Ukraine conflict will weigh on already-weak investment activity. The conflict will damage both short and long term Russias growth. However, it has good enough reserves (about onethird of GDP) to withstand moderate Western sanctions for an extended period. The conflict will be a drawn-out and volatile affair, whichever scenario plays out. What are the possible scenarios? Our baseline scenario (currently 65% probability)1 assumes that the situation will gradually stabilise, without open military conflict in Ukraine. Sanctions will therefore remain targeted towards specific individuals and businesses, and thus Western economies will experience no significant negative impact on their growth, i.e., recovery in Europe will keep picking up. Russia will enter a shallow recession in 2014 and will largely stagnate during 2015 (GDP growth at 0.8% in both years). For the Baltic economies, this scenario means slower growth than previously expected, but no recession. Worse scenarios will kick in if the conflict escalates: more and broader sanctions from the West, energy supply interruptions from Russia, higher energy prices, somewhat slower growth in Europe, and a deeper recession in Russia. For the Baltic economies, this means a single-digit recession. What are the channels via which the effect will feed? For the Baltic economies, links with Ukraine are minor, and its importance currently is mainly that of a political hotspot of regional instability and confidence. The negative impact would come predominately through the links with Russia. The negative impact from the conflict can be transmitted via four main channels: foreign trade channel: exports to Russia (and Ukraine and other economies closely integrated with Russia) to suffer due to the rouble devaluation and possible temporary/ selective trade barriers introduced by Russia or its customs union; investments channel particularly for Russiarelated businesses, but possibly also for others if overall confidence weakens;

Background The Ukraine is a politically, ethnically, and economically divided state, with extreme corruption levels; in general, Central and West Ukraine politically is pro-Europe, while South and East Ukraine is pro-Russia. Ukraine is very close to economic collapse and will avoid a bust only if the political situation stabilises and the West provides necessary funding.
Contribution to Russia's GDP growth, pp
20

10

-10
Households Gross fixed cap. formation Net exports -20 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 '14f '15f Source: Russian Federal State Statistics Service, Swedbank forecasts Goverment Change in stocks GDP

Russia is structurally and institutionally weak to generate fast and sustainable economic growth consumers have been the key driver of growth over the past few years, but they are now running out of steam. Unemployment has bottomed out, wage growth is slowing, and rouble devaluation will push up inflation. Exports picked up in the second half of 2013, but its recovery will be weighed down

Swedbank Economic Outlook, April 8, 2014

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nonresident financial flows banks and real estate; confidence, which can amplify the impact via general investment and consumption activity.

Latvia's goods' exports to Russia in 2013, % of total goods' exports in the specific sector
Other manufactured goods Textiles Non-metallic minerals Precious metals Machinery and equipment Optical instruments etc. 8 9 11 11

Goods' exports to selected countries (2013), % of total goods' exports

35% 30% 25% 20% 15% 10% 5% 0% Estonia Source: national statistics Latvia Lithuania Note: BY - Belarus, UA - Ukraine, RU Russia, FI - Finland, PL - Poland BY& UA BY& UA Other Baltics

12
12

Other Baltics
RU

FI

Other RU Baltics

Transport vehicles Pulp and paper

BY& UA

14
15 18 19 46 0 10 20 30 40 50

RU
PL

Chemicals Plastics and rubber

PL
FI

Prepared foodstuffs Source: CSBL

FI

Lithuania's goods' exports to Russia in 2013, % of total goods' exports in the specific sector
Other manufactured 15 20 20 24 27 30 31 34 37 40 40 10 20 30 40 50 Of Lithuanian origin Headline Metals Animal products

Foreign trade integration of the Baltics and Russia Russia is an important export market for the Baltic economies, but not the major one. Official statistics are likely to underweight the share of goods and services exports to Russia (e.g., some of Latvias exports to Russia may be directed through Estonia and Lithuania), and a more realistic guess would be about 15-20% of total exports. Note that a big part of trade is re-exports. For instance, about 20% of Lithuanian goods exports go to Russia, but of that only 15% are of Lithuanian origin (this also means that only about 5% of Lithuanian-origin goods are exported to Russia). This implies that the transport sector is more exposed to Russian trade than manufacturing. The Baltic export flows are affected by (i) the purchasing power of Russians (i.e., their incomes and the rouble exchange rate), and (ii) possible barriers and other impediments to foreign trade introduced by Russia. The latter is nothing new, and businesses are used to this (e.g., the most recent example concerns an import ban on dairy products from Lithuania in the second half of last year, but one can also recall an ad hoc ban on selling Latvian canned fish during Luzhkov years as mayor of Moscow).
Estonia's goods' exports to Russia in 2013, % of total goods' exports in the specific sector
Transport vehicles Other manufactured goods Metals Pulp and paper Plastics and rubber Machinery and equipment Textiles Animal products Optical instruments etc. Chemical products Prepared foodstuffs 0 Source: Statistics Estonia 10 20 30 7

Prepared foodstuffs
Textiles Pulp, paper Transport vehicles Optical instruments

Construction materials
Machinery, equipment Vegetable products 0 Source: Statistics Lithuania

In case of falling demand, companies can reduce the loss of trade if they can reduce their prices and profit margins; this they now stand a good chance to do in view of their improved financial stance over the past few years (e.g., good profitability, accumulated deposits, and reduced leverage). It is more difficult to counteract outright trade bans or barriers. But past experience shows that companies have been quite agile in downsizing quickly and/or finding other markets/products to compensate for the decrease in trade with Russia. It is doable, but, of course, it takes time and cost. The above charts, which plot the Baltics goods exports structure to Russia, show that direct exposure is that of specific companies and sectors, not a comprehensive, acrossthe-board negative impact. In many sectors, Russias share is quite small and manageable. The major sectors that are likely to be affected are the following: Manufacturing. But the major impact is limited to certain industries (e.g., food processing) and companies. Transport and transit in general. For example, in Latvia about 77% of freight transported by railway is directly Russia related. But Russia has been very vocal for many years that it will aim to redirect its transit flows through its own ports (e.g., the UstLuga port), and this conflict will only speed up this long-term trend. For instance, some of this we saw last year in Estonian transit flows. Possible impact on tourism. For example, in 2013, 25% of foreign guests accommodated in Latvian hotels were from Russia (respectively, 20% in Lithuania and 17% in Estonia).

7 8
8 10 14 15 15 20 27 31 40 50

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Imports from Russia are limited, and for most products alternative suppliers are available (including oil products). The exception is natural gas, for which Russia is the only supplier at the moment. Natural gas constituted 9% of gross energy consumption in Estonia, 27% in Latvia, and 36% in Lithuania in 2012. The high dependency of Lithuania on imports of mineral products is mainly because of only two companies an oil refinery (which is supplied with crude oil from Russia and would need to adjust its production process if switching to other type of oil) and a fertiliser producer (which is very dependent on natural gas).
Goods' imports from Russia in 2013, % of total imports in the specific sector
40 30 84 Estonia Latvia Lithuania

these banks can downsize very quickly. Nonresidents have been important in the luxury real estate segment in Riga and its vicinity. Decreased activity in this segment may have a negative impact, but it would be limited to the top segment. Impact on the Baltics from the conflict So far, we see very little if any negative impact on economic activity in the Baltics from the Russia-Ukraine conflict. The conflict is still very fresh, and its impact on macro data will be seen only with a delay. The latest business and consumer confidence measurements are available from early March, and they have been largely stable. What is currently feeding through is the depreciation of the rouble, which, as of April 14, has fallen vis-a-vis the euro by 23% from a year ago and by 10% from the beginning of this year. This has made Baltic exports to Russia more expensive.
Rouble exchange rate

20
10

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 25 20 30 EUR/RUB (reversed) USD/RUB (rs, reversed) 25

Chemicals

Wood products

Mineral products

Metals

Pulp & paper

Fats & oils

Total

35
40 45 35 50 55 Source: Reuters EcoWin 40 30

Source: national statistics

The major risk would be natural gas supply interruptions, which would increase uncertainty and cost and thereby also negatively affect the Baltics ability to export elsewhere. Yet, Russias ability to cut off the gas supply is mitigated by an underground storage facility in Latvia, although the gas stock ownership rights are unclear; a liquefied natural gas (LNG) terminal in Lithuania, operational in late 2014; Finland and Estonias plan to build an LNG terminal in two-three years; and the limited on-site storage facilities of the Kaliningrad region and the supply of gas by Russia via Lithuania, which means that a potential supply interruption would be temporary. Capital flows between the Baltics and Russia It is hard to assess how big Russian and Ukrainian investments in the Baltics are, since capital may flow in/out via related companies in other European countries. According to official statistics, the share of Russian investments in total foreign direct investment (FDI) stock is about 5% in Latvia and Estonia, and 4% Lithuania2 (Ukrainian investments are at 0.8%, 0.5%, and 0.1%, respectively). In turn, the share of Latvian FDI stock in Russia is 4% of the total (and nearly as much in Ukraine). For Estonia, these shares are nearly 5% and 6%, while for Lithuania they are 5% and 2%, respectively. Nonresident (including Russian) deposits and real estate purchases are more important in Latvia than in other Baltic countries. However, most of the Latvian banks focusing on nonresident clients are niche banks that are nonsystemic, and their regulation has strengthened in recent years (e.g., their liquidity ratios are much higher than those for domestically oriented banks). In previous years, we have also seen that
2

The confidence developments are the most uncertain and hard to predict. If economic sentiment does not worsen significantly and the Russia-Ukraine conflict does not escalate, with sanctions remaining at about the current level (i.e., the baseline scenario), the Baltics will continue to grow, but slower than anticipated before. We forecast in 2014 about 3% growth for Latvia and Lithuania, and 1.8% for Estonia (for more details, see the Swedbank Economic Outlook, April 2014). The fall in exports to Russia will be compensated for by rising exports to a recovering EU. With slower economic growth, labour markets in the Baltics will heat up less unemployment will fall slower and, thus, wage pressures will not be as strong as anticipated in our January Outlook. Public finances will remain robust. The negative impact will dissipate during the next year, and we anticipate growth in the Baltics of 3-4% in 2015. However, if confidence in the Baltics dives and/or the conflict escalates, Baltic economies will be hit harder. In worse scenarios, the Baltics would see recessions, especially if Russia interrupts energy supplies and raises trade barriers significantly. However, even in this case, recessions in the Baltics will be substantially milder than the double-digit economic decline of 2008-2009. We are still in the baseline scenario, but developments in recent weeks in Ukraine show that the situation could be shifting towards worse scenarios.

Mrti Kazks, +371 6 744 58 59, martins.kazaks@swedbank.lv Lija Strauna, +371 6744 58 75, lija.strasuna@swedbank.lv

Lithuanias data for the first nine months of 2013.

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