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, ek.sekr@swedbank.se, 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
ek.sek@swedbank.se
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 Sea
Analysis.

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 forecast
GDP growth (%) 2007 2008 2009 2008 2009
USA 2.0 1.7 1.1 1.5 1.5
EMU countries 1.4 0.8 1.6 1.4
of which: Germany 2.5 1.8 0.6 1.8 1.4
France 2.2 1.2 0.8 1.7 1.5
Italy 1.5 0.5 0.2 0.6 0.9
Spain 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 1.3
China 11.9 9.8 8.7 10.0 9.0
India 8.9 6.9 6.4 7.2 7.5
Brazil 5.2 4.7 4.0 4.7 4.0
Russia 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
jan
06
apr jul okt jan
07
apr jul okt jan
08
apr jul
Index
20
30
40
50
60
70
80
90
100
110
120
130
140
Ukraine
Russia
Sweden
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 rce : R e u te rs E co W in
0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8
Procent
-1 0
0
1 0
2 0
3 0
4 0
5 0
6 0
7 0
8 0
L e ttla n d
U kra in a
P o le nR yssla n dL ita u e n
E stla 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 zone
Domestic credit to the private sector/GDP (%) 78.1 38.3 45.2 31.0 122.0
Listed companies’ market capitalization/GDP (%) 28.0 42.6 31.4 87.2 72.9
Financial 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 GDP
Foreign 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 rce : R e u te rs E co W in
ja n a p r ju l o kt ja n a p r ju l o kt ja n a p r ju l
0 6 0 7 0 8
0
5
1 0
1 5
2 0
2 5
3 0
3 5
U kra in e
L a tvia
R u ssia
E sto 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
C
om
m
odities
Chem
icalproducts
Interm
ediated
goods
M
achinery/equipm
ent
Various
finished
goods
1995
2000
2007
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 2007
Germany 1.8 1.8 1.7 18
Finland 10.9 10.6 9.8 9.9
Norway 15.7 14.3 14.9 14.6
Denmark 9.7 8.9 8.9 10
Estonia 13.4 13.9 14.1 14.4
Lithuania 2.7 3.4 3.3 3.7
Latvia 6.3 5.1 5 4.9
Russia 2.7 2.3 1.9 1.8
Ukraine 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
Government: Market-oriented coalition
Prime Minister: Yuliya Tymoshenko
President: Viktor Yushchenko
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.
- 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
Government: Conservative coalition
Prime Minister: Andrus Ansip
President: Toomas Hendrik Ilves
Next parliamentary election: March 2012
Next presidential election: September 2011
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.
- 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
30
Lithuania
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
Government: Conservative coalition
Prime Minister: Ivars Godmanis
President: Valdis Zatlers
Next parliamentary election: October 2010
Next presidential election: June 2011
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.
- 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 Q1
00 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
Government: Center/left coalition
Prime Minister: Gediminas Kirkilas
President: Valdas Adamkus
Next parliamentary election: October 2008
Next presidential election: June 2009
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.
- 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
Government: Liberal conservative
Prime Minister: Donald Tusk
President: Lech Kaczynski
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.
- 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
Government: Grand coalition CDU/CSU/SPD
Prime Minister: Angela Merkel
President: Horst Köhler
Next parliamentary election: September 2009
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.
- 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
Government: Liberal–Conservative coalition
Prime Minister: Anders Fogh Rasmussen
Next parliamentary election: by 2011
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.
- 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.
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
Government: Coalition between Center Party
and Social Democrats
Prime Minister: Matti Vanhanen
President: Tarja Halonen
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.
- 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.
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
Government: Coalition between Labour,
Socialist Left and Center
parties
Prime Minister: Jens Stoltenberg
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.
- 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.
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
Government: Moderate coalition
Prime Minister: Fredrik Reinfeldt
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.
- 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
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
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
Jan
07
A
pr
Jul
O
ct
Jan
08
A
pr
Jul
O
ct
Jan
09
A
pr
Jul
O
ct
Jan
10
A
pr
Jul
O
ct
CPI
CPIX
CPI Swedbank
CPIX Swedbank

Sweden forecast
Swedbank’s economic forecast for Sweden
September 2008
Supply balance sheet
Change in volume (%)
2006 2007 2008P
1)
2009P
1)
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

Baltic Sea Report September 2008

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Baltic Sea Report September 2008