Fitch Ratings says in a special report that the Baltic states face a challenging and uncertain 12 months as they undergo a rapid macroeconomic adjustment in a difficult global economic and financial environment. All three countries have Negative Outlooks on their Long-term foreign currency Issuer Default ratings (IDR) of 'A' for Estonia, 'BBB+' for Latvia and 'A' for Lithuania. The agency expects the Outlooks and ratings to be driven by the nature and cost of the adjustment underway in the Baltic economies.

"After years of strong, and ultimately unsustainable, growth fuelled by massive capital inflows and rapid credit growth, a necessary slowdown is underway in the Baltic economies. However, the downturn is sharp in Estonia and Latvia and they are at risk of recession, heightening downward pressure on creditworthiness," says Eral Yilmaz, Associate Director in Fitch's sovereigns group.

Real year-on-year GDP growth has plummeted to a negative 1.4% in Q208 in Estonia from 4.8% in Q407 and to just 0.2% in Latvia from 8.1%. The slowdown in Estonia and Latvia has been led by a fall in investment, particularly into real estate, and private consumption, which has also slowed import growth. Credit growth has weakened and property prices have fallen around 20% in the past year. Lithuania's economic boom was more modest and, consequently, its imbalances are less marked. It is also experiencing a slowdown in real GDP growth, although it started later in Q307 and growth was 5.5% in Q208.

Furthermore, inflation rates are high, wage growth is robust and external finances remain over-stretched. At 16.5% in July 2008, Latvia's year-on-year inflation rate was the highest in the EU while, Lithuania's (12.4%) and Estonia's (11.2%) were the third- and fourth-highest, respectively. Fitch forecasts Latvia's current account deficit at 18.2% of GDP in 2008, the second-largest in the EU, Lithuania's at 14.5% and Estonia's at 12.7%.

"An orderly unwinding of macroeconomic imbalances would likely lead Fitch to revise the Outlooks back to Stable," says Ms Yilmaz. However, that depends on the confidence of residents and foreign banks, continuing financing for the current account deficit and prevention of the spike in inflation feeding into higher price expectations, as well as on how quickly wage growth will moderate and on whether industry can restructure to increase exports."

A recession or protracted slowdown, particularly in conjunction with persistent high inflation, deteriorating competitiveness, and problems in the banking sector, or devaluation of the Baltic currencies - which is not Fitch's central scenario - would likely lead to a downgrade.

The ratings of all three Baltic states are underpinned by their strong public finances and low government debt ratios, strong medium-term growth prospects as well as the political and institutional strengths associated with their membership of the EU. Estonia's government debt burden was just 2.7% of GDP in 2007, the lowest in the EU and among 'A' range credits; Latvia's was just 10% and Lithuania's 17%. Furthermore, all three countries are net public external creditors. The high level of ownership of the banking system by Nordic banks, which Fitch believes are committed to long-term investments in the Baltic countries and will continue to provide support to their Baltic subsidiaries, is also a rating strength.

However, a prolonged downturn would have a detrimental affect on budget balances and bank asset quality and could undermine confidence, while the fragile global environment adds to financing risks. Fitch believes devaluation is unlikely, but not impossible if the downturn proves long and deep and if there were loss of confidence in the Baltic currencies and their banking systems, triggering a widespread conversion and withdrawal of deposits.