Over the past year, Scope Ratings has observed significant shifts in the creditworthiness of the Baltic states. Estonia experienced a downgrade to A+ (from AA-), while Lithuania received a Positive Outlook on its single-A ratings, and Latvia maintained its A- rating. These adjustments reflect a growing divergence in macro-fiscal risks, with Lithuania and Estonia converging while Latvia increasingly separates.
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While all three Baltic nations boast some of the lowest public debt levels within the euro area, distinct fiscal policies are leading to divergent debt trajectories, exacerbated by uneven economic performance across the region. This divergence raises questions about each nation’s resilience to potential escalating geopolitical risks stemming from the ongoing conflict in Ukraine and uncertainties surrounding global trade policies.
Fiscal Challenges: Defense Spending and Rising Interest Costs
Recent shocks, persistent inflationary pressures, and increased defense spending (approximately 3-4% of GDP annually) due to heightened geopolitical tensions have contributed to rising fiscal deficits across the Baltic region. Although direct military threats related to the conflict in Ukraine remain low due to NATO membership, the proximity to Russia exposes these nations to spillover effects, including cyber threats and disinformation campaigns. This protracted conflict introduces significant uncertainty to medium-term fiscal outlooks.
Furthermore, while expected to gradually decline, elevated interest rates will contribute to rising interest payments across the region. Net interest payments are projected to reach 1.5%-3.0% of revenue over 2024-29, a notable increase from the 0.5%-1.5% observed in 2023.
Estonia’s fiscal balance is projected to improve slowly due to weak economic momentum and structural spending increases in areas like education and social policy. Despite implementing additional fiscal consolidation measures, the government deficit is anticipated to remain at 3.1% of GDP in 2024 and 2.9% in 2025.
Latvia faces similar challenges, with a projected fiscal deficit of 3.1% of GDP in 2024 and 3.0% in 2025, influenced by revenue pressures from an upcoming labor tax reform. Lithuania’s deficit is expected to widen to 2.5% of GDP in 2025 due to indexation mechanisms and fiscal stimulus, before gradually declining in subsequent years driven by strong tax revenue growth.
Divergent Growth Trajectories: Lithuania Leads the Way
Lithuania’s economy has outperformed its neighbors, with estimated growth of 2.3% in 2024 and a projected 2.9% in 2025, fueled by recovering private investment and robust household consumption.
A significant rebound in Lithuania’s manufacturing sector, partly due to stronger ties with Poland’s rapidly growing economy, contrasts with the struggles faced by Estonian and Latvian manufacturing due to their exposure to weaker construction markets in Finland and Sweden. Lithuania’s economic resilience is further bolstered by strong services exports, reflecting a shift towards higher-value-added sectors like financial services and IT.
In contrast, Estonia experienced a prolonged recession in 2022, with output contracting by an estimated 0.9% in 2024. A gradual recovery is expected, with 1.6% growth projected for 2025, but tax increases may hinder private demand. Latvia, after a post-pandemic rebound, faces stagnation with a projected 0.2% contraction in 2024 before a potential 1.5% recovery in 2025 driven by improving consumption.
While improving external demand should support regional growth in 2025, the outlook remains clouded by the fragile euro area economy and global trade uncertainties. External competitiveness, particularly amid high nominal wage growth, remains a key concern for all three Baltic economies.
Declining Interest Rates and Credit Growth Dynamics
Easing financing conditions and low leverage should support domestic demand in the near term. Lithuania, experiencing increased credit growth due to strong business and household confidence, is poised for a recovery in private investment.
Conversely, Latvia faces persistent challenges in credit extension to the private sector. The recent lifting of US sanctions and the establishment of a Nordic Investment Bank hub in Riga offer positive signals, but a new levy on banks’ net interest income could constrain credit supply.
Conclusion: Navigating Divergent Paths
The Baltic states, while geographically proximate, are navigating increasingly divergent economic and fiscal paths. Lithuania’s robust growth and positive fiscal outlook contrast with the challenges faced by Estonia and Latvia. The interplay of geopolitical risks, global economic uncertainties, and domestic policy choices will continue to shape the individual trajectories of these nations in the years to come. Monitoring these diverging trends is crucial for investors seeking opportunities and understanding risks within the Baltic region.
