Egert Juuse

Title: The Risks and Failures of External Financing of Development in Small States: The Case of the Baltic States

Supervisor: Prof. Dr. Rainer Kattel

Opponent: Prof. Dr. Jan A. Kregel

Defense: 14 June 2010

Abstract: The thesis gives a synthetic overview of the financial, institutional and economic challenges external financing of development poses for small states and their development. The theoretical framework interrelates classical development economics traditions with Minsky-Kregel conceptual framework and institutional set-up of financial systems to analyze the financial fragility and crisis in the Baltic States that have been under the strong influence of neoliberal policies and Washington Consensus regime. As the inward FDI in the Baltic States has been concentrated in limited number of economic sectors and tend to finance the production of maturing products that face saturating markets and diminishing profits, FDI in the Baltic States is becoming mature in terms of both shrinking new FDI inflows and thriving FDI related income outflows. Furthermore, propensity to consume rather to invest and domestic market orientation of FDI have eroded the margin of safety by insufficient generation of foreign currency earnings to meet the external liabilities. Unrestricted capital inflows have been feeding monetary expansion in these countries, which led to inflationary trends and deteriorating real exchange currencies, all of which supported widening current account deficits. Both fixed exchange rate systems, including currency board arrangements in Estonia and Lithuania in the context of free capital flows that did not prevent high inflation, and overall liberal economic policies that left policy-makers only with traditional macroeconomic policies (taxes and expenditures) as the main tools to alleviate external imbalances, are to blamed in deteriorating financial conditions in the Baltic States. Governments have mainly relied on different fiscal policy measures before and after the crisis, while prudential capital-account controls, specific FDI policies, and more elaborated regulations on banking activity have been left aside.

Keywords: Development economics, FDI, exchange rate systems, macroeconomic policies, financial fragility and crisis.