Christian Ketels: Uncertainty fences off investments in the region

While the Baltic Sea region is doing better than the rest of Europe, an uncertain outlook is inhibiting investment activity and weakening economic growth. In this interview, Dr Christian Ketels of the Harvard Business School shares his views on what’s behind the uncertainty and what the financial sector can do to improve the climate.

Christian Ketels, Principal Associate at the Institute for Strategy and Competitiveness of the HarvardBusinessSchool, has been the lead author of the State of the Region Report for ten years. The report is an annual publication produced by the international networking organisation Baltic Development Forum for its summits arranged in different cities of theBaltic Sea region. In 2013, the summit was held in Riga,Latvia.

The focus of the State of the Region Report in 2013 is on the uncertainty that dominates the economic outlook for the region five years after the financial crisis broke out. The Baltic Sea region is still doing better than the economies of Southern Europe, but the post-crisis recovery has slowed down significantly and the region is deeply affected by the trends on the European mainland. The Top of Europe remains a part of Europe, for better or worse, says the report.

“Our competitiveness fundamentals are quite strong, but our region is not immune to negative trends,” says Dr Ketels.

“We shouldn’t forget that domestic consumption is a big part of economic activity also in small countries such as in a large part of the Baltic Sea region. As long as it keeps on bumping along based on solid competitiveness, it will make sure that we don’t drop off the cliff.”

“Exports, especially net-exports, are a much smaller share of GDP. But they are among the most important transmission channels of the external crisis, given our huge exposure to the European market. If the rest of the European economy continues to be weak, it will continue to weigh on our region as well.”

In identifying scenarios for Europe’s development in the coming years, the report suggests that the following types of experiences are most relevant: (1) Japan’s lost decades, or a lengthy deep recession, which neither a succession of spending programmes, nor a lenient monetary policy will be able to avert; (2) the Baltic tiger redux, or a very deep recession cured with so-called ‘internal devaluation’ with deep fiscal and wage cuts; and (3) ‘crisis – devaluation – recovery’, or recovery after a more or less painful devaluation driven by economic crisis, with the specifics driven by the sequencing of individual policy actions.

“I don’t think we are heading towards another full-blown recession. What we need to be concerned about is a Japan-style scenario with low-growth rates and little dynamism,” says Dr Ketels. Is he sceptical about a recovery happening soon?

“Financial crises take longer to work themselves out. I don’t believe in a quick, hockey stick recovery. In the US, a country with a lot of competitiveness issues of its own, you nevertheless see a more standard development, i.e. an economic drop followed by a return to growth,” he continues.

In Europe, the problem that has led to the financial crisis persists, and as proof of this Dr Ketels points to a widening gap between actual dynamics and what is calculated as potential GDP growth. He quotes the report saying that investment flow is weakening despite the provision by central banks of large amounts of liquidity. The promise of low interest rates is obviously not enough to drive business investment.

“A lot of it has to do with the uncertainty about the future scenario. Europe is very diverse, many policy issues are still in the balance, and there is no clarity in how we are going to deal with this,” he says.

Dr Ketels acknowledges that austerity has played a positive role in the region.

“In Europe, we worry very much, and for good reasons, of the devastating effect of inflation and public debt. The big European trauma is hyperinflation, like in the Weimar Republic. But the danger is that the steep cyclical downturn is now eroding a lot of the progress many European economies have made on competitiveness fundamentals like skill and infrastructure,” he says.

“One has to be smarter in looking for a right recipe—which is not about spending more—but also be careful not to make the problem worse. In Latvia, for instance, there were a number of government cuts, then GDP dropped more and the government had to make more cuts. Eventually, Latvia managed to stabilise its economy, thanks to a financial system that remained intact and exports that quickly started to grow.”

Dr Ketels believes that Latvia has won credibility through its painful internal devaluation and by being committed to the policy of joining the euro. Will joining the euro help improve the competitiveness of individual countries?

“In order to solve their competitiveness issues, the Baltic countries need to move to the next level, competing on more than the relatively low wages. The countries are fully aware of the challenges. They see clearly what needs to happen. The critical challenge is the implementation of business infrastructure, regulations and skills,” says Dr Ketels.

The financial market has an impact. Dr Ketels agrees with NIB’s President Henrik Normann that one needs to look at the financial sector from different angles: while large companies have the advantage of refinancing themselves at very attractive rates, small and medium-sized enterprises (SMEs) face a larger problem, because banks look at risks.

“Given the difficult economic climate, credit demand from SMEs is naturally limited. But there is also a supply issue: more stringent regulation makes it less attractive for banks to lend to SMEs, and the low monetary policy rates are translated into higher margins for banks, not lower interest rates for companies.”

A strong SME sector stabilises employment and creates domestic demand. The challenge is that under current market and regulatory conditions banks have little incentives to lend to SMEs.

“Core industrial companies are the engine that will drive the region forward, but SMEs are the transmission mechanism that translates this engine into broad-based economic activity,” says Dr Ketels.

Alongside the focus on SMEs, Dr Ketels stresses that international financial institutions play a key role in financing long-term large-scale projects:

“Investments in public infrastructure will continue to have a major impact on the region’s development and stabilisation of local economies. We have clear needs in energy, infrastructure, innovation, clean technologies, and that’s what NIB traditionally does. This is as important as ever, both for stabilising demand and enhancing competitiveness,” Dr Ketels concludes.