The three small Baltic states of Lithuania, Latvia and Estonia have found themselves on the frontline of Russia’s invasion of Ukraine in more ways than one. As well as having to ramp up their defence posture to meet the increased Russian military threat, they also face a severe challenge to cope with the economic fallout from the invasion. Trade links with neighbouring Russia and Belarus are being sanctioned or hampered, boosting food, energy and other prices, creating the risk of stagflation.

The Baltic states are currently clocking up the highest inflation rates in the European Union. In March, Lithuania had the highest inflation in the EU, at 15.7%; in Estonia, it was 14.8%; in Latvia 11.5%, according to Eurostat, the EU’s statistical office.

Lithuania’s inflation rate was the highest figure since October 1996, mainly boosted by increases in energy and food prices, Statistics Lithuania, the country’s chief statistician, says. But compared to that earlier period, the Balts’ central banks today have fewer tools to fight inflation, because, as members of  the eurozone, they cannot use interest rates or the exchange rate to curb inflation, leaving only fiscal policy.

The slumping spending power of the euro and the ‘cosmic’ prices of goods are now on the lips of most Lithuanians.

Saulius Cepkauskas, owner of JSC Vlasava, a passenger transportation company in Palanga, one of the most popular tourist resorts in Lithuania, tells bne IntelliNews that he is “surprised” how his small company has managed to survive at all.

“First, there was the blow of the COVID-19 pandemic and now spiking fuel prices, inflation. I think I already lost track of how much the prices have risen over the last year – over 60% for sure. And just in the wake of the war they went up in double digits over a single day,” he says.

Grappling with the effect of inflation on his business, Cepkauskas has shelved some projects, focusing on the most key ones and on paying salaries in time.

“My daily care is to think how to pay wages in time. So far, we manage to do that, but if fuel prices continue edging upwards, well, I don’t now…,” he says.

Viktoras, owner of a bakery in Klaipeda, Lithuania’s third-largest city, tells bne IntelliNews that he cannot rule out that the inflation will finish off his mom-and-pop business, which is struggling compared to the large chain bakeries.

“The prices of flour are already galloping, and the disruptions of wheat supplies are already plaguing the market. But with the devastation in Ukraine and sanctions against Russia – the two are some of the biggest grain exporters in Europe and beyond – we cannot even speak about a good harvest in the autumn,” the baker says.

Ballooning consumer prices are making it more difficult for people to afford everything from groceries to their utility bills. As energy prices rose last winter, heating bills soared 100-150% for Lithuanian households. This depresses consumption, creating the risk of economic recession.

“Now the cost of meeting basic needs – heating, food – is rising. This is especially critical for people with lower incomes. Simply put, if you could barely make ends meet at the older prices, now you are completely out of options,” says Vytautas Snieska, professor at the Faculty of Economics and Business of Kaunas University of Technology (KTU).

Old ties bind

Spiking energy costs are the main factor driving inflation in Europe, with those prices surging 44.7% y/y in March, compared to 32% in February, according to Eurostat. This pushed up euro area average annual inflation to 7.4% in March, smashing the high in February, when it surged to 5.9%. It's the fifth straight month that inflation in the eurozone has set a record, bringing it to the highest level since record-keeping for the euro began in 1997.

The main reason for the leap in the Baltic state’s inflation rate is their high dependence on Russian energy, dating back from their half a century as part of the USSR.

“Until the [Ukraine] war, Russia had remained an important player in our energy mix. The alternative energy sources we had until now were more expensive than the [Russian] gas,” says Sigitas Besagirskas, president at the Vilnius Industry and Business Association (VIBA), uniting over 350 companies in the Vilnius region.

The share of Russian gas in domestic consumption has been declining over the last couple of years – from 32% in 2019 to 26% last year, Laura Sebekiene, communications head of Amber Grid, operator of Lithuania‘s natural gas transmission system, tells bne IntelliNews. Nevertheless, Lithuania’s energy dependence on Russia was still one of the highest among the European countries before the war.

Lithuanian Swedbank economist Nerijus Maciulis estimates that Lithuania paid some €2.7bn for Russian oil products last year, with an additional €140mn spent on Russian gas and €180mn on Russian electricity.

Despite this dependence, with the outbreak of the war, Lithuania was one of the first EU countries to announce its plans to immediately abandon Russian gas and electricity, though Latvia and Estonia would struggle to follow its lead.  Gazprom’s gas pipeline from Russia still accounted for around 30% of Lithuania’s supply mix last year, which is still too high to sail smoothly through an emergency like a full halt of Gazprom gas imports. Latvia and Estonia remain even more dependent, at 90% and 79% of gas consumption respectively. 

Cutting trade ties with Russia more generally will be painful, though these were already being reduced, and the Balts had already imposed sanctions on Belarus. In terms of the direct impact on the Lithuanian economy, the Bank of Lithuania says that it will be limited due to the reduced ties between the Lithuanian economy and financial system and Russia. From the last quarter of 2020 to the third quarter of 2021 exports to Russia comprised 6% of total Lithuanian exports, whilst export to Ukraine and Belarus amounted to 6% and 3%, respectively, the bank says.

However, it admits that Russia’s aggression in Ukraine will still have a negative impact through reduced exports and disruptions to imports of raw materials.

Some experts also blame other factors for the Balts’ current economic predicament. Besagirskas says not only geopolitics or “energy wars” are to be blamed for record-high inflation in Lithuania.

“Amid the war, some people in the Lithuanian government would like to sweep it up under the rug and/or chalk it up to the war and the other contingencies, like the migrant crisis on the Lithuanian-Belarusian border. But it was the government that allowed Taiwan to open a Taiwanese Representative Office in Vilnius. In retaliation, China severed ties with our companies depending on Chinese components and substituting them has been costly,” the VIBA head emphasises.

The office in the Lithuanian capital carries the name “Taiwan” rather than the capital Taipei, which is used by many foreign nations to avoid offending China. Infuriated by the decision, China recalled its ambassador from Vilnius and downgraded the embassy last year.

Lithuanian businesses are now being frozen out of China markets, leading the EU to accuse Beijing of “illegal" trade practices. The EU has now taken the case to the World Trade Organisation, but with the Ukraine war in the backdrop, the case will probably be bogged down for years there.

“What we see now is that many Lithuanian companies are buying the materials and the components, most of whose origin is the same China, for a higher price. As Lithuania is an industrial country, depending significantly on imports, the loss has been painful,” Besagirskas says.

According to him, Lithuania’s lax fiscal policies are also partly to blame for the soaring inflation, particularly given that fiscal policy is the only tool available to a eurozone member to fight inflation. The government earlier this month revised upwards its forecast for the budget deficit to 4.9% of GDP.

“State debt is record-high and we see tons of money still being pumped in – the previous Farmer and Greens-led government did that, citing COVID-19, and the current one does that too, citing a bunch of reasons. Considering that we will soon see a new sign-off of EU money, the money supply in the country will continue ballooning,” the VIBA head says.

Shock scenarios

Due to the ongoing uncertainty over the Ukraine war, it is extremely difficult to predict the future course of economic growth and inflation in the Baltic states, says the Bank of Lithuania. Therefore, its economists have prepared three scenarios instead of regular forecasts.

Under the conventional scenario, based on the information available on March 1, Lithuania’s GDP is projected to grow by 2.7% this year, while inflation is projected at 10.5%.

In the shock scenario, which is based on assumptions and financial market information until March 17, the country’s GDP will increase by 0.4% and the inflation will be at 11.1%.  In case of a greater shock scenario, hypothetical additional shocks to the economy are projected which would lead to a decrease of GDP by 1.2% in 2022 and the inflation rate would be at 11.5%.

Some economists and analysts  do not rule out the possibility of even a recession in Lithuania this year. They believe that the situation will depend on the course of Russia’s war in Ukraine, as well as the consequences of Western sanctions against Russia and the surge in global energy prices.

The inflation rate and slowing growth, coupled with the COVID-19 pandemic, the migrant crisis on the 670-kilometre Lithuanian-Belarusian border and the inevitable fallout to the country’s economy from sanctions against Russia and Belarus will certainly backfire on Lithuania’s Liberal-Conservative government, analysts say, although the blame game for now remains overshadowed by the war in Ukraine.

“Indeed, paying a price for the COVID-19 pandemic, the policies it was implementing and, now, for fallout from the war is inevitable [for the government]. Once the war in over, all the attention will be on the economy, which, judged by most by the prices on the shelves, does not look very good,” Vytautas Dumbliauskas, associate professor of Vilnius-based Mykolas Romeris University, tells bne IntelliNews.

The liberal-Conservative Lithuanian government has put together a plan to alleviate the effects of inflation. The government has announced it will increase pensions, social benefits, tax-exempt income and child allowances. It is also offering subsidies on heating and for household electricity consumers. Observers say, however, more effort may be needed within months – and it may have to include measures that the government rejects today, such as pegging salaries to inflation.