Lithuania: Cold Winds Blowing from the East

The year 2014 will be seemingly the best year for Lithuanian economy. Surely not only because Lithuania succeeded in negotiating yet another EUR 6.7 billion package from European Union, which sweetened the celebration of the tenth anniversary of EU membership. Firstly, Lithuania became the first among the Baltic States to reach the pre-crisis GDP level, which is an impressive achievement given that Lithuanian economy contracted by as much as 14.8% in the year 2009 alone. Secondly, Lithuanian GDP per capita (in PPS) increased to 75% of average EU level and for the first time in living history surpassed that of Greece and Portugal. This achievement is highly symbolic as it challenges the deep-rooted perception about the poor Post-Soviet Eastern Europe and the rich Western Europe (or at least what concerns the southern part of it). Thirdly, Lithuania has met all the Maastricht criteria and will become the 19th member of eurozone in January 1, 2015. This is again an impressive achievement given that Lithuania managed to reduce its budget deficit from 9.4% to a mere 2.2% in just 4 years. Mario Draghi prized Lithuanian experience as a “Baltic success story,” which showed good example to other eurozone countries “that adjustment is not only necessary, but also possible—even without currency devaluation.” And finally, in a couple of weeks Lithuania will finish the construction of liquefied natural gas (LNG) terminal, which will substantially decrease Lithuanian energy market dependence on politically capricious Russia.

And yet as Mr. Murphy would remark “if situation seems too good to be true, it probably is.” In spite of remarkable economic achievements, the year 2014 brought an event that may have a damaging effect on Lithuanian economic development for many years, if not decades, to come. An ongoing economic war between Russia and the European Union, triggered by geopolitical tensions in Ukraine, threatens erecting yet another Berlin Wall (should rather be called “Donbass Wall”). This threatens to deprive Lithuania of its status as a bridge between the East and the West and could push Lithuania to the periphery of Western civilization—just as Western Berlin once was. And yet, I argue that the situation is not as dangerous as it may appear—looking at a number of studies predicting that Baltic region in general and Lithuania in particular would perish, or at least undergo severe recession if the relations between Russia and the West will come back to the Cold War times.

Statistics and Reality

There are lies, damned lies, and statistics. Statistically, as much as 19.8% of Lithuanian exports were directed to Russia in 2013—the highest rate in the whole European Union. However, large majority of goods exports are re-exports (85%), which is essentially a westeast transit of goods from the Western Europe to Russia and other CIS countries. Exports of Lithuanian origin (excluding re-exports) to Russia accounted for a mere 4.8% of overall exports of Lithuanian producers. In this respect, Russia is only the 8th largest export partner of Lithuania after Germany, Latvia, Estonia, UK, Netherlands, Poland and Sweden. This implies that trade disruptions with Russia would have comparably limited effect for Lithuanian producers.

Transport sector (primarily road transport) is far more vulnerable with close to 30% of total export revenues coming in from Russia. Slowdown of Russian economy, weakening ruble and potential trade disruptions will restrict west-east movement of goods. Hence, transport sector revenues from Russia may fall by as much as 25–35% in 2014 and 2015. However, even this magnitude is not extraordinary: similar fall was observed in 2009, whereas a massive drop of 60% during the Russian economic crisis in 1999 was by far of greater magnitude.

Extraordinary Flexibility

It is not the first time Lithuania experienced temporary import bans from Russia. For example, in October-December 2013 Russia banned all dairy imports from Lithuania during the so called “milk war.” However, this apparently did not have any material long-lasting negative effects on Lithuanian dairy industry. Lithuanian producers were flexible enough to find new export markets for their products ranging from Central Asia to Middle East and China. Exports to other Eurasian Customs Union countries (Belarus, Kazakhstan) also had a tendency to increase, suggesting that some of these products were later “re-exported” to Russia. Another “economic war” episode occurred in end-2009 when Russia imposed stricter border control procedures several months before the creation of the Eurasian Customs Union. Exports fell by close to 50%, but this ban did not have any material long-term effects either (in fact, exports to Russia were growing very fast both in 2010 and 2011). Hence, if history is to repeat itself again, the ultimate effect of Russian economic sanctions on Lithuanian producers will be somewhat limited.

As a consequence of this, existing Russian economic sanctions (i.e. import ban on meat, fish, fruit, vegetables and dairy imports from all EU countries for the period of one year starting from August 7, 2014) will have somewhat limited effect on Lithuanian economic growth ( 0.8 p.p. of GDP). Hence, in spite of existing economic sanctions, Lithuanian economy should remain in positive GDP growth territory both in 2014 and 2015. Furthermore, Lithuania’s Baltic sisters—Latvia and Estonia—would have even lower negative effect (0.4–0.5 p.p. each); hence the whole Baltic region should remain one of the fastest growing regions in the EU despite the Russian sanctions. Obviously, if situation were to escalate further with Russia and the EU exchanging counter and counter-counter sanctions, then the effect would be bigger, but this scenario is highly unlikely. First of all, other Eurasian Customs Union members (in particular Belarus and Kazakhstan) do not support further sanctions against the European Union. Secondly, the European Union, being dependent on Russian energy resource imports, will be highly unwilling to extend sanctions (at least before the heating season starts).

High Dependence on Russian Gas

Formally, Baltic States in general and Lithuania in particular seemingly have an exceptionally high dependence on Russian gas imports. First of all, in all of these countries Russia is the sole supplier, providing 100% of natural gas imports. Moreover, none of these countries at present have alternative sources of gas imports with the only gas supply channel being Yamal-Europe gas pipeline, operated by Russian government-owned gas export monopoly Gazprom. In addition, none of the countries extract their own gas (even though attempts are being made to look for shale gas in the Baltics) thus making the gas market fully dependent on Russian imports.

Majority of imported gas in Lithuania is consumed by industrial companies (i.e. fertilizer producers consume close to 50% of overall Lithuanian gas imports), which are important players in Lithuanian labour market and account for a significant share (3%) of Lithuanian exports. Is spite of increasing usage of renewable energy sources (e.g. wind, biofuel), Russian gas still remains among the most popular resources for energy generation in Lithuania with gas-powered plants supplying close to 25% of overall electricity consumption (2012). Gas is also widely used for heat generation in all the Baltic States with the share of gas in central heating system still standing at close to 50%. Hence, in case of gas supply disruptions, the effect on Lithuanian economy would be considerably larger than the existing ban on food product imports.

However, high dependence on Russian gas should not be confused with supply insecurity, since security of gas supply not only depends on import dependence, but also on other factors such as the existence of gas storage facilities, availability of substitutes, the status of a country as a transit country or development of new energy security enhancing projects.

First of all, Lithuanian gas energy security is enhanced as a result of its status as a transit country to Russian Kaliningrad district, which receives 100% of its gas supplies via Lithuania. Existing underground gas storage facility in Kaliningrad district is able to supply Kaliningrad with only 7–12 days of gas consumption while Nord Stream offshore gas pipeline, running directly from Russia to Germany via Baltic Sea does not have a branch to Kaliningrad. Moreover, according to the existing agreements, Lithuania has a right to reduce transit volumes to Kaliningrad proportionally to the import volumes from Russia, hence if Lithuania would suffer, so would Kaliningrad.

Secondly, the risk of gas supply disruptions is significantly reduced due to the existence of Incukalns Underground Gas Storage Facility in Latvia, which has a capacity to store up to 2.32 billion m3 of natural gas (140% of annual Latvian consumption). The facility plays very important role in enhancing gas supply security not only in Latvia, but in the Baltic region as a whole. It buys gas from Russia in summer (when demand is low) and sells it in winter to their customers in Latvia, Estonia, Lithuania and even Russia itself. In this respect Finland, for example, is much more vulnerable to unforeseen gas supply disruptions, since it has no large scale storage facilities. To reduce this vulnerability, Finland is implementing “Balticconnector” gas pipeline project, which would connect Finland to the Baltic grids and would allow access to the Latvia’s natural gas storage facilities in Incukalns (expected: 2016– 2018).

Finally, Lithuania is in the final stages of building Klaipeda LNG terminal, which is scheduled to begin operations on December 2014. The terminal has a capacity to supply up to 2 billion m3 of natural gas per year (~2/3 of annual consumption in Lithuania) and would provide real alternative to Russian imported gas (gas supplier—Statoil). In addition, Lithuania fully implemented The EU’s Third Energy Package, which will enable to create competitive and transparent gas market (as a consequence of its efforts to liberalize gas market, Lithuania was paying the highest gas import price for the last couple of years).

In addition, Lithuania is carrying out other energy security-enhancing projects: construction of NordBalt (700MW) cabel between Lithuania and Sweden and LitPol Link (1000MW) cabel between Lithuania and Poland, which are expected to be completed by the end of 2015. This would reduce the need to use gas powered plants for electricity production, which covers around 25% of overall electricity consumption in Lithuania. Heating sector is also expected to move almost completely towards renewable energy sources. To achieve this aim, Lithuania will use 2014–2020 EU funds to build renewable energy cogeneration plants in the biggest cities—Vilnius and Kaunas.

The Only Thing We Have to Fear Is… Fear Itself

During his first inauguration speech in 1933, Franklin D. Roosevelt told to crisis-troubled American citizens that “the only thing we have to fear is… fear itself.”The same idea would perfectly fit the Russian-sanctions-hit Lithuanian society. First of all, Lithuania should focus on plenty of opportunities that come from the West, rather than allow being paralyzed by anxieties and phobias that come from the East. Lithuania should exploit the existing (a hard-working and educated labour force) and to promote the new centres of future growth (attracting high-tech from the West via direct investments and generating in-house high-tech ideas by promoting research and development activities). Lithuania should also focus on more efficient usage of generous EU funds.

Secondly, Lithuania should resist the temptation to overspend and continue pursuing responsible fiscal policies. And finally, Lithuania should continue carrying out vital economic reforms, which would help Lithuania become one of the most business-friendly countries in Europe. Geopolitical and economic turbulences in Russia should not become an excuse for postponing reforms, investments and action. Lithuania has a good opportunity to become one of the leading countries in the EU. Otherwise, there’s a good chance that Lithuania will be caught in longlasting slow growth or even stagnation trap. Which way Lithuania will follow depends only on her.