External deficits in the Baltics 1995 to 2007: Catching up or imbalances

This paper studies external deficits in the Baltics between 1995 and 2007.It uses a calibrated small-open-economy dynamic general equilibrium model incorporating a financial accelerator to assess to what extent deficits can be explained by productivity growth, fall in spreads and increasing access to credit.Results suggest that the external deficit and other key macroeconomic aggregates can be well fitted by the equilibrium response of the model economy. Real convergence is found to have been dominant in the first half of the sample. More reversible financial factors became increasingly important towards the end of the period pointing to growing vulnerability. Positive growth outlook is also likely to have played a significant role in the build up of the foreign debt. Reversal scenarios confirm the need for a sizable readjustment.