Do the Baltics deserve a second look? Scrutinising the

reasons for investor skepticism

Peeter Piho, Swedbank Investment Funds

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May 2010

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The Baltic states

ESTONIA

LATVIA

LITHUANIA

GDP: €16.2bnPop: 1.34 mln

GDP: €18.3bnPop: 2.26mln

GDP: €27.7bnPop: 3.34mln

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Rise of the Baltics: 2000 – 2007

Continuous GDP growth at average rates ofapproximately 8.3% in Estonia, 8.7% in Latviaand 7.5% in Lithuania, facilitated by:

•stable currency rates based on currency boards in Estonia (since 1992) and Lithuania (1994), fixed exchange rate in Latvia (1994)

•strong, compliant and innovative banking system dominated by large Scandinavian banks since late ‘90s

•investor friendly economic policies

•simple, advanced taxation principles introduced early (flat income tax in all three countries, no corporate income tax in Estonia)...

... But most importantly by:

•Strong FDI inflow

•Cheap credit widely available for banks to be onlent to companies and individuals.

-15

-10

-5

0

5

10

15

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009(f)2010(f)

Real GDP Growth Rate (%)

Estonia Latvia Lithuania EU27

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Fall of the Baltics 2008-2009:

GDP plunged hitting double-digit levels

Latvia bailed out by the IMF, Lithuania borrowing in the market to compensate for deficit.

Prompt devaluation of currencies was widely expected by foreigners across the winter 2008-

2009.

Export opportunities vanished due to the global crisis.

Consumer confidence dropped to all-time lowest level

After acute lack of labour up to 2007, unemployment skyrocketed within 12-18 months from ca.

4-5% to 14-17%

Banks panicked and cut lending to corporate sector; loan portfolio decreasing

Whole region generally despised by the investors’ community

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Before it all happened, investors had their say

In 2008 investors had said:

Your economies are unbalanced and need to

be delevered

Your currencies are overvalued and currency

pegs will not hold

Your assets are too expensive...

... and did not invest any moreForeign Direct Investment Inflow (% of GDP)

Estonia, EEK Latvia, LVL Lithuania, LTLSource: Reuters EcoWin

Mar Jul Nov Mar Jul Nov Mar Jul Nov Mar Jul Nov Mar Jul Nov

05 06 07 08 09 10

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

EXTERNAL DEBT/GDP 1.10.2009

0%

20%

40%

60%

80%

100%

120%

140%

160%

LAT SLK HUN EST SLV BUL LIT ROM POL CZK

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Exploring debt burden

0%

20%

40%

60%

80%

100%

120%

140%

160%

Estonia Latvia Lithuania

Banks FDI related Government Other

Gross external debt (% of GDP, Q3 2009) Nominal debt is high but there are few things to highlight:

-Financial sector debt accounts for >50%. It’s all Nordic

banks’ loand to their Baltic subsidiaries;

-Another big chunk is FDI related

-Government’s share negligible even after Latvian IMF

package and Lithuanian 2008/2009 bond programs:Government debt 2009

0%

10%

20%

30%

40%

50%

60%

70%

80%

Estonia Latvia Lithuania EU 27

Source: Eurostat

Most of the debt not actually collectible – Scandinavian banks not in position to call their loans.

The Baltic countries (except Latvia, for fiscal reasons) did not actually face liquidity crisis.

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Exploring debt burden – financial sector

Baltics total (EUR 75.4 bln)

Five largest banks have over 75% of the market share which is similar to Nordic countries

• Banking sector highly concentrated

• Scandinavian banks dominate the market

in Estonia totally, in Latvia/Lithuania

minority controlled by locals

Latvia (EUR 30.0 bln)

Lithuania (EUR 24.8 bln) Source: local banking associations and FSAs, centrals’ bank data. Data as at end 2009

SEB; 20%

Nordea;

13%

DnB Nord;

2%

Swedbank;

49%Danske;

10%

Unicredit;

2%Parex; 1%

remaining;

5%

SEB; 14%

Nordea; 10%

DnB Nord; 9%Danske; 1%

Parex; 17%

Unicredit; 4%

Hypoteku; 4%

Aizkraukles; 0%

remaining; 18% Swedbank; 23%

Swedbank; 22%

Nordea; 10%

DnB Nord; 14%

Danske; 7%

Unicredit; 1%

SEB; 30%

Parex; 2%

remaining; 1%Snoras; 7%

Siauliu; 2%

Ukio; 5%

DnB Nord;

9%

Parex; 7%

Unicredit; 2%

Nordea; 11%

Swedbank;

30%

remaining;

15%

Danske; 5%

SEB; 21%

Estonia (EUR 20.6 bln)

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Lending before and after September 2008• Combination of abundance of cheap

international credit and small size of the Baltic

markets pushed banks to fuel the loan growth

for years.

• Lehman crisis triggered a panic and banks

pulled the breaks. By Feb 2010 they have

taken out over EUR 2 billion purely from

corporate clients.

• Some of that reduction was prudent, some

clearly an over-reaction, and some needs to be

substituted by more appropriate capital.

• Deleverage represents ca 7% of the portfolio in

2008 and ca 6% of pre-crisis GDP.

• The key question is what will the banks do next

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Interbank Rates, 6 Month

TALIBOR RIGIBOR VILIBOR EURIBOR

04 05 06 07 08 09 10

0

2

4

6

8

10

12

14

16

18

20

Exploring exchange rate risk

Currency pegs in place:

Estonia (kroon, EEK) Currency board since 20.06.1992 (initially fixed vs.DEM)

Latvia (lats, LVL) 01.01.2005 pegged to the €, +/-1% range. 1994-2004 was pegged to SDR basket of 4 currencies;

Lithuania (litas, LTL) Currency board; 02.02.2002 at a fixed exchange rate against EUR. 1994-2002 fixed vs.USD

In 2008/2009 the market believed that devaluation

is underway, starting from Latvia

27%

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Devaluation unlikely from the beginning

Symbolic status of the pegs – overlooked by foreigners

It would not have resolved problems due to open nature of the economies

Substantially all bank loans in the Baltics have been nominated in euros, correct. But collection in € when currencies devalued

All relevant parties against devaluation:

• Government

• Banks

• Entrepreneurs

• People (=mortgage borrowers)

Loan exposure in the Baltics

162

172

95.489.9

0

20

40

60

80

100

120

140

160

180

200

bn S

EK

Loan exposure in the Baltics

Shareholders' equity

- Would have triggered credit losses for leading banks in the magnitude jeopardizing their capital base (see chart);

- Would have hit private individuals –borrowers; that would have been politically unacceptable;

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Response 1Internal devaluation instead of nominal exchange rate adjustment

Countries opted for adjustment via domestic labour market and fiscal tightening. Massive wage and employment cuts have proven the flexibility of real economy and labour market.

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Labour market flexibility has supported internal adjustment

Source: Carley

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Response 2Fiscal tightening

Governments cutting costs heavily:

Estonia and Lithuania voluntarily;

Latvia under IMF programme;

Estonia with it’s budget position at -1,7% one of 5 EU countries that met Maastricht criterion in 2009.

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Consequences 1Loss of external competitiveness has now been stopped

Internal devaluation takes generally longer time to have a meaningful effect.First positive signs in export performance started to emerge at the end of 2009.

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Consequences 2Economic grounds for devaluation have effectively been removed

15

Source: EurostatSource: Eurostat

-6

-4

-2

0

2

4

6

8

10

12

14

16

18

Inflation (HICP) growth (%)

Estonia Latvia Lithuania EU Average

-1400

-1200

-1000

-800

-600

-400

-200

0

200

400

600

800

Balance of payments, current account (EUR mln)

Estonia Latvia Lithuania

Estonia’s euro accession

Maastricht criteria as of end 2009

Criterion Target value Estonia

Inflation 1,5% 0,2%

Government debt 60,0% 7,2%

Budget balance -3,0% -1,7%

Interest rates 6,1% N/A

Latvia and Lithuiania targeting to join in

2014

12 May publication of Estonia’s convergence report

June recommendation of euro-area Member States

8 June ECOFIN meeting, discussion of Estonia's compliance

18 June the European Council discusses Estonia's readiness to join the euro area

13 July ECOFIN's final decision about Estonia’s accession

1 Jan 2011 Eurozone entry

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2010 - 2011 Time to enter for daring investors

From macroeconomic point of view:

Acute recession is over. Export is a key to set the pace for recovery.

Estonian eurozone entry will add stability to entire region. Devaluation currently off the table, internal adjustment instead of exchange rate.

Painful cost-cutting done, competitiveness improved.

In the market, almost no PE backed deals over the last two years. It will change since:

Availability of financing still restrained, fundamentally healthy companies seeking replacement capital.

Extensive, diverse pipeline across the region and sectors.

Valuation gap narrowed down.

Revival of private equity (and property) investors’ interest visible.

Strategic investors already buying (2 major delistings)

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Thank you!

Peeter.piho@swedbank.ee

+372 613 1582

+372 503 0130