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Thanks to currency boards that have fueled strong growth, Estonia, Latvia and Lithuania are now pressing for early adoption of the single currency.

Searching desperately for stability after breaking away from the Soviet Union, politicians in the tiny Baltic state of Estonia decided in June 1992 to peg their fledgling currency, the kroon, to the deutsche mark. The decision was as much an expression of hope as a well-thought-out economic strategy. The country's inflation rate had exploded to more than 1,000 percent, its fragile banking system was verging on insolvency, and the political system was convulsed by a bitter debate over the imposition of tough citizenship requirements on Estonia's big Russian minority population. Amid such chaos there was no guarantee that the currency peg would deliver prosperity. As a political act, however, the decision spoke volumes. Emerging from five decades of Soviet domination, Estonia was determined to tie its future to Western Europe's.

"The signal effect was very important," recalls Märten Ross, deputy governor and head of policy at the Estonian central bank. The decision to peg the kroon to the mark was, he says, "a clear commitment to European integration."

Today Estonia is reaping the benefits of that commitment. The country of 1.3 million people joined the European Union this month along with seven other Central European nations, Malta and Cyprus. In contrast to the continued sluggishness of the EU, Estonia's economy is expanding at a clip of more than 5 percent annually. Thanks to liberal economic policies, investment has flowed freely across the Baltic Sea from Sweden and Finland, fostering the development of the country's banking and telecommunications industries, while cheap labor has helped domestic producers export growing volumes of goods and services.

"More and more, you can see that Estonia will be the southern part of Finland," says Indrek Neivelt, chief executive of Hansabank Group, the largest bank in the Baltic states, based in the Estonian capital of Tallinn.

Estonia's success is mirrored by that of its Baltic neighbors, Latvia and Lithuania. The two countries followed Estonia's example and based their economic strategies upon fixed currency pegs to the West as well as on open trade and investment policies.They, too, have experienced an upsurge in growth and investment. Lithuania, which, with 3.4 million people, is the largest Baltic country, boasted a torrid 8.9 percent growth rate last year, the highest in Europe, while Latvia expanded by an impressive 7.5 percent. The Baltic states' deepening economic integration with their richer neighbors in Scandinavia and Germany promises to make them Europe's tiger economies of this decade, paralleling Ireland's performance in the 1990s.

The currency pegs also make the Baltics the most likely candidates among the new EU members for early adoption of the euro. Both Estonia and Lithuania plan to seek admission to the EU's revamped exchange rate mechanism, known as ERM II, this summer as a prelude to adopting the euro by 2007 (a move that Slovenia also is expected to make). Latvia plans to apply for ERM II membership at the end of the year after it changes its currency peg to the euro from the SDR, the IMF's currency basket, which includes a big dollar component. This enthusiasm for early euro adoption stands in stark contrast to the situation in larger accession countries like Poland, Hungary and the Czech Republic, where budgetary and political problems have pushed the likely date for euro adoption back to 2010 or after. EU officials have been urging these countries to get their own economies in order before tackling the euro. In April, European Central Bank president Jean-Claude Trichet, speaking before a committee of the European Parliament, emphasized that "it is of the utmost importance that countries fulfil the convergence criteria both in a nominal and a real -- namely, sustainable -- manner before they join the euro area."

"The fact that we have been running a fixed exchange rate regime for some time means it is in our interest to join sooner rather than later," says Roberts Grava, head of market operations at the Latvian central bank. "It could be seen as reducing risk for our economy."

Notes Lithuanian EU Commissioner Dalia Grybauskaité, who took up her post this month after serving as the country's Finance minister for three years: "We practically have the euro already. The currency board system means we only have to change the name."

To be sure, the Baltic states will face significant challenges even after joining the European Union. Like Eastern Europe's other young democracies, they suffer from political instability, as the recent impeachment of Lithuania's president and the resignation of Latvia's prime minister have underscored. The three countries are also running big current-account deficits that would leave their economies vulnerable if foreign investment dries up. And the transition to the euro could pose difficulties if inflation heats up or if the EU authorities insist that the Baltics devalue or revalue their currencies before entry.

Despite all the potential pitfalls, however, the Baltic countries' commitment to open trade and investment policies, low tax rates and closer integration with Western Europe should foster continued strong growth in the years ahead. "Estonia is a small, open country. This is our advantage," says Taavi Veskimägi, the country's boyish, 29-year-old Finance minister. "We want to be attractive for foreign investors."

The countries also are likely to exert a liberal influence on policy within the EU. Estonia plans to lower its 26 percent tax rate on personal and corporate income to 24 percent next year and to 20 percent in 2007. The corporate rate applies only to distributed profits; retained earnings aren't taxed at all, a fact that could make Tallinn a potential relocation site for multinationals seeking to minimize taxes. Lithuania's corporate tax rate is 15 percent, the lowest of the EU accession countries.

"We expect we will be able to catch up economically, gain know-how and use our experience in reforming ourselves" once inside the European Union, says Lithuania's Grybauskaité. "We are more liberal than some EU member states."

The eagerness to embrace Western institutions -- including NATO, which the Baltic states joined in March -- is widely shared among the eight Central and Eastern European countries that entered the European Union this month. The EU and NATO membership represent their definitive inclusion in the West after decades of Communist rule. But unlike the other accession countries, which were satellite states under Moscow's heavy hand, the Baltics were part of the Soviet Union until its breakup in 1991. This made the transition to a free-market economy more painful: Economic output plunged by a third in Estonia after the collapse of the Soviet Union and by about 50 percent in Latvia and Lithuania, and it remains below 1989 levels in all three countries, according to estimates by the European Bank for Reconstruction and Development. But the despised Soviet heritage also ensured a much greater degree of public support for economic reforms -- ranging from the discipline of currency boards to unfettered access for foreign investors -- than in most other accession countries.

"The Baltic states were clearly occupied countries," says Toomas Luman, chairman of construction company EE Grupp and head of the Estonian Chamber of Commerce and Industry. "Nothing in the economy was our own. All structures were Soviet structures. It was much easier to change everything."

Says Vanessa Mitchell-Thomson, principal economist at the EBRD: "The rejection of all things Russian has been the main feature of all their policies. That's why they embraced reform so quickly."

Russia still casts a long shadow over the region. In Lithuania, President Rolandas Paksas, a former Soviet stunt pilot, was impeached last month because of close ties to Jurijus Borisovas, a shadowy Russian businessman who financed Paksas' campaign and has been accused by Lithuanian security services of selling arms to Sudan. The Seimas, the country's parliament, voted to remove Paksas for violating the constitution by tipping off Borisovas that his telephone was being tapped and for granting him Lithuanian citizenship. The chairman of the Seimas, Arturas Paulauskas, has temporarily assumed the presidency until an election is held this summer.

Additionally, Russia has been quick to use its economic clout for its own advantage. Its state-owned pipeline monopoly, Transneft, has sharply cut the flow of oil that it exports through Latvia during the past two years in an apparent attempt to win lower transit charges and obtain a Russian stake in Latvia's Ventspils Nafta oil terminal, which the government wants to privatize. Russian private enterprise also has invested actively in the region: Two years ago oil company Yukos acquired a 27 percent stake in Lithuania's Mazeiku Nafta, which owns the only oil refinery in the Baltics.

Another legacy of the Soviet era is the political instability that plagues the region. In February, while Lithuania was undergoing its impeachment crisis, the 15-month-old coalition government of Latvian prime minister Einars Repse collapsed because of corruption allegations stemming from Repse's purchase of several properties using cut-rate bank loans. Estonia has endured frequent changes of coalition governments. Mindaugas Jurkynas, a professor at Vilnius University's Institute of International Relations and Political Science, contends that the collapse of the Soviet Union left the Baltic states without well-rooted political parties; affiliations tend to be driven more by personality than by ideology. "This is a very favorable milieu for attempts to gain personal political benefits," says Jurkynas.

Lithuanian officials hope that Paksas' impeachment will mark a big step forward in the country's political maturity. "It's a clear sign that we are changing and reacting to scandals with proper means, with democratic procedures and the rule of law," says Gintaras Steponavicius, deputy chairman of the Seimas. "It's not only about the president. It's the first step toward changing attitudes toward corruption generally."

Despite bouts of domestic political turmoil, all three Baltic states have succeeded in maintaining a remarkable degree of stability in economic policy. "Most people agree on the basics -- that's the great thing about the Baltics," says Gert Tiivas, president of Baltic operations at OM HEX, the Stockholm-based exchange operator that controls the Tallinn and Riga bourses and is negotiating to acquire the National Stock Exchange of Lithuania. "No one has questioned NATO, the EU or the broad thrust of economic reforms."

Investor confidence in the Baltics' economic outlook was driven home earlier this year when Latvia and Lithuania both tapped the Eurobond market at record low interest rate spreads in the midst of their domestic political crises. In February, Lithuania issued E600 million ($750 million) of nine-year bonds at a spread of 47 basis points over German government bonds; the next month Latvia sold E400 million of ten-year bonds at a spread of 44 basis points over German bonds.

Domestic politics "are background noise as long as there is multiparty consensus on the EU, fiscal discipline and the euro," says Samad Sirohey, director of debt capital markets at Citigroup Global Markets in London. "There's no radical shift in policy based on political change."

Estonia has led the way for the Baltics on economic policy, and the currency board has been an integral part of the country's success. After the collapse of the Soviet Union rendered the ruble worthless almost overnight, Estonia in 1992 was facing hyperinflation. Inflation had soared to 1,076 percent, a rate that was effectively duplicated in Latvia and Lithuania.

The Estonian government responded by adopting a currency-reform package that replaced the ruble with the kroon and tied the new currency to the deutsche mark at a fixed rate of 8 to 1. Inflation plunged to 90 percent in 1993 and continued to decline steadily, hitting a low of 1.4 percent last year. Currency reform "clearly removed inflation from the economy," says the central bank's Ross.

Just as important as the currency peg's immediate impact on inflation was its broader influence on Estonia's laissez-faire economic orientation. In the dying days of Soviet rule, Estonia had taken advantage of perestroika to allow the creation of ten commercial banks, and the subsequent disintegration of the Soviet Union caused a crisis in the fledgling banking system. The temptation for the government to prop up the banks was great, but the discipline of the currency board -- which required the country's leaders to run a balanced budget to support the paramount objective of currency stability -- ruled out a big state bailout or other heavy-handed intervention, Ross notes.

The currency board has also helped Estonia's Baltic neighbors. "Generally, I think the system has been beneficial to our economy because it has eliminated any political interference" in monetary policy, says Reinoldijus Sarkinas, chairman of the Bank of Lithuania.

Estonia's currency board passed its biggest test during the Russian debt crisis in 1998. Russia's default and the subsequent plunge of the ruble sent shock waves that brought down U.S. hedge fund Long-Term Capital Management and threatened a global financial panic. But Estonia's currency board acted as an anchor that helped the country ride out the crisis and avoid contagion. "There was so much fragility around that without the guidance to the public of the fixed-currency regime, there would have been more nervousness," says Ross.

The Russian crisis also spurred the radical restructuring of Baltic trade away from Russia and toward Western Europe. Today Estonia sells more than 80 percent of its exports to EU members -- 40 percent alone go to Sweden, Finland and Germany. Russia accounts for less than 4 percent of Estonia's exports and less than 9 percent of imports. Although Russia plays a somewhat larger role in the trade accounts of Latvia and Lithuania because it ships some of its oil and gas exports through those countries, the overall trend is similar. "The Russian crisis really helped us tremendously," says Lithuanian central banker Sarkinas. "Our exports shifted from Russia to Europe in a period of one and a half years."

The stability provided by Estonia's currency board has played an equally pivotal role in attracting foreign investment, particularly in banking. In November 1998, Sweden's SEB Group paid 840 million krooni ($60 million) for a 32 percent stake in Eesti Ühispank, the country's second-largest bank. At the same time, SEB made similar investments in Latvijas Unibanka of Latvia and Vilniaus Bankas in Lithuania. Today it has full control of all three banks and boasts the biggest banking presence in the Baltics, with 1.7 million retail customers, up from 500,000 five years ago.

"No one could actually understand that growth would reach the pace it has," says Mats Kjaer, the SEB executive who oversees the Baltic operations. "What we have seen is a dramatic change in the cities. You can physically feel that something new is happening every day."

SEB and its competitors, including Hansabank and Norddeutsche Landesbank Girozentrale, are fueling a boom in the construction of new housing, shopping centers and offices across the region. Housing is especially hot as consumers take advantage of expanded bank credit and rising disposable incomes to satisfy pent-up demand from the Soviet era. SEB's mortgage lending grew 40 percent in Estonia last year and 60 percent in Latvia and Lithuania -- and it doesn't appear that it will cool down any time soon. Mortgages represent less than 15 percent of SEB's total loan exposure in the region, compared with 50 percent in Scandinavia.

"Our economy is now able to support itself with internal consumption," says Lithuanian EU Commissioner Grybauskaité. "The construction industry is booming."

This fast growth reflects another Baltic advantage: the region's receptiveness to innovation and technology. Take Hansabank. Since its founding in 1991, the bank has embraced open-architecture information technology systems, adopting Unix-based hardware and Oracle software. It doesn't issue checkbooks, and customers use direct debit or the Internet to handle most payments. Only 4 percent of payments go through Hansabank's branch network. More than 1 million of its 3.5 million customers do their banking online -- a remarkable figure considering that only about 35 percent of Baltic homes have fixed-line telephone connections.

"We went to the masses, and we taught people how to use a bank," says Hansabank CEO Neivelt. "We started from scratch. We don't have a mainframe. We don't have legacy problems. There is no separate Internet bank."

SEB, meanwhile, is looking to take advantage of the strong skills of its Baltic workforce. Fully 60 percent of its employees in the region have university degrees, compared with 30 percent in Scandinavia. The bank has set up an information technology service center in Estonia and shifted the management of its Central European mutual fund from Stockholm to Tallinn. "We have a competence base that we are using in different ways," says SEB's Kjaer.

When foreign investors have a complaint about the Baltics, it's usually about the region's lack of integration. While outsiders expect synergies among the three countries with a combined population of just 7 million, the Baltics regard themselves as fiercely independent countries with distinct histories and cultures. Predominantly Lutheran Estonia has a natural affinity with Finland and Sweden; Catholic Lithuania enjoys strong ties with Poland, with which it was united in the 16th and 17th centuries. Catholic Latvia, on the other hand, trades heavily with the U.K. and Germany while retaining strong energy links with Russia.

"The differences between the three countries are bigger compared with the Nordic countries," says SEB's Kjaer. "You have different languages, different religions and different behavior. But you have to find efficiencies across the three countries."

Foreign investors are struggling to find those efficiencies. Take TeliaSonera, the Swedish-Finnish telephone operator that holds majority or controlling stakes in the leading Baltic telephone companies. TeliaSonera must maintain separate IT platforms for mobile media services in each of the Baltic countries; in Scandinavia, however, it has a single technology platform to cover Finland, Denmark, Norway and Sweden. The company is seeking to reduce costs by negotiating less expensive roaming agreements among the Baltic operating companies, but those steps fall well short of what it would do if it had full ownership. "If you can do things together, the whole package will be cheaper," says Kenneth Karlberg, TeliaSonera's president for the Baltics, Denmark and Norway.

Another challenge for investors is the rivalry among the Baltic states. This surfaced most dramatically early this year when the Lithuanian government rejected a bid from Estonia's Eesti Energia for a controlling stake in power distribution company Rytu Skirstomieji Tinklai, despite the fact that the Estonian company was the only bidder at the privatization. Officials cited the fact that Eesti Energia was itself state-owned, but many bankers believe that Lithuania was not ready to see a major industrial company pass into the hands of a rival Baltic state.

Lithuania's Grybauskaité dismisses the suggestion that the Baltic states should deepen cooperation, saying that the government's priority is closer integration with its new EU partners. "The Baltic countries have never had a common interest," she bluntly asserts. "We have been competitors. Lithuania has more in common with Poland and Germany."

Despite the differences among the three countries, the integrating force of commercial logic is making itself felt. In March the Lithuanian government chose a bid from Stockholm-based OM HEX over a joint offer by the Warsaw Stock Exchange and Paris-based Euronext for a 54.5 percent stake in the National Stock Exchange of Lithuania. OM HEX already operates the Riga and Tallinn exchanges and aims to develop a pan-Baltic market, but some bankers had feared that regional rivalries would swing the deal to Warsaw and Euronext.

OM HEX's Tiivas notes that efforts to forge a regional Baltic exchange foundered in the 1990s because none of the national bourses wanted to cede dominance to a neighboring rival. The stalemate ended when Finland's HEX, with deep pockets, strong technology and, perhaps most important, no Baltic roots, bought the Tallinn exchange in 1999. The lesson, as Tiivas puts it, is that "the way to Baltic cooperation goes through Helsinki."

The euro promises to force further integration, both among the Baltics and with their new EU partners. Estonia and Lithuania plan to apply to enter ERM II, once the EU agrees on the ground rules in June or July. Latvia intends to follow suit early next year after changing its currency peg from the SDR to the euro.

The Baltic states' track record of successfully operating fixed-currency regimes for a decade or more should make euro adoption "a foregone conclusion" says Helge Berger, an economist at the Free University of Berlin. The clear exit strategy that the peg to the euro represents, unlike Argentina's former peg to the dollar, helps reassure investors and reduces the risk of a speculative attack. Even the International Monetary Fund, usually not an advocate of currency pegs, is sanguine. An IMF study last year found "no clear evidence of exchange rate misalignment that would call into question the underlying competitiveness of the Baltic economies or the sustainability of their exchange rate regimes."

But there are risks, even for the Baltics. The main one stems from their current-account deficits. Estonia ran a massive deficit equivalent to 15.3 percent of GDP last year, well above the level that would trigger a currency crisis in almost any other emerging-market economy. Surging imports of capital goods and construction materials combined with the sluggish growth of exports to the stagnant EU economy to exacerbate Estonia's deficit. Stronger growth in the EU should reduce the deficit to about 13 percent of GDP this year, the Finance Ministry projects, but in almost any scenario the deficit will remain daunting for the foreseeable future. Last year the deficits in Latvia and Lithuania were smaller, at about 9.2 percent and 6.6 percent of GDP, respectively, but still substantial.

So far Estonia has succeeded in financing its deficit with strong inflows of foreign direct investment. Since 1989 FDI has totaled more than $2.5 billion -- about $1,850 for every person, a higher per capita figure than that of any EU accession country except the Czech Republic and Hungary. Officials are confident those flows will continue. "If you don't see high investment inflows, then something's wrong," says Estonian central banker Ross. "A deficit of 6 to 8 percent of GDP over five to seven years is something we would expect to see."

A slowdown in FDI could expose the Baltics to the kind of damaging currency speculation that Hungary suffered last year. According to EBRD chief economist Willem Buiter, that risk is a major flaw in EU rules, which require euro candidates to spend at least two years in ERM II before joining the single currency. "The very large current-account deficits run by the Baltic economic and monetary union candidates strengthen the case for these countries' earliest possible full participation in EMU," Buiter wrote in a recent paper. "Having an independent national currency would increase both the likelihood of a crisis and the severity of any crisis that does happen."

Flawed or not, ERM II is a fact of life for the Baltics. Estonia plans to guard against the risk of any currency weakness by maintaining a balanced budget in coming years. The country's low debt levels -- government debt amounts to just under 5 percent of GDP -- also support its euro ambitions. "I want to keep a very conservative government financial position," says Finance Minister Veskimägi.

For most business executives -- foreign and local -- the Baltics' combination of sound policies, currency stability and a strong growth outlook appears to make it one of the safest bets around.

"Here it is possible to get synergies from the developed Scandinavian and Western European countries with the lower cost levels of the Baltic republics," says the Estonian Chamber of Commerce and Industry's Luman. "In the next 20 years, this will be the fastest-growing region of Europe."