Bulgaria, Romania and the three Baltic States are vulnerable to economic shocks because they have the widest current-account deficits in the European Union, Moody’s rating service said.

Latvia, Lithuania, Estonia, Bulgaria and Romania have current-account deficits in the EU equal to or exceeding 10% of GDP. These countries also have fixed or heavily managed exchange rates, which limit the ways they can control inflation, producing „a recipe for financial disaster,” Moody’s said in a policy perspective report today. Current-account gaps ranging from 10.7% of GDP in Romania to 21.8% of GDP in Latvia, threaten their economies with withdrawal of foreign lending and ensuing output contraction, making them „inflammable” the report said.

The extent of „inflammability” depends on the nature of financing, where foreign direct investment „is less subject to abrupt reversals, than bank debt.” In Bulgaria and Romania, the deficit is financed mostly by foreign investment, while in the three Baltic states it is fueled more by lending from parent foreign banks to their local subsidiaries and by foreign commercial debt, the report said. The economies of these countries are expanding at the highest pace in the EU as they work to reach income per capita levels of richer states in the West.The report forecasts that GDP per capita will double in the next 20 years, based on the experience of Greece, Spain and Portugal, which joined the EU in 1980s. Rising labor productivity has partly compensated for the widening current-account deficits. Stable exchange-rate regimes have contributed to the expansion of credit in the EU’s five poorest members, as borrowing in euros has appeared cheap, the report said. Domestic credit growth in 2006 ranged from 14% in Bulgaria to 58% in Latvia.The „explosive pace of credit growth” fueled imports and consumption widening the current-account deficits. Latvia, Lithuania and Estonia are members of the EU’s exchange-rate mechanism, a required two-year test of currency stability, while Bulgaria said it wants to join this spring. The three Baltic states postponed plans to adopt the euro as soon as possible because of fast inflation. In Latvia, the national currency, the lats, fell to an all-time low on March 16, forcing the central bank to sell euros on the domestic market in an effort support it.„Ironically, a hard landing may facilitate” euro adoption as the overheated economies of the Baltic states cool, they might be able to meet euro-adoption criteria sooner, the report said. Euro region „accession will eliminate in one strike most of the external debt, but will not obviate the need to spur productivity growth as real incomes naturally converge.”Fears that the five EU states are headed for a repeat of the 1997 Asian Crisis are „misleading,” because EU membership ensures a real-income convergence and „reduces the risk of a sudden halt to external financing.” Moody’s said. Between 65% and 85% of all bank assets in these countries are owned by „reputable” EU-based foreign banks. „EU membership reduces both the probability of a balance of payment crisis and, even more, its possible severity,” the report said. „It is hard to believe that EU banks could walk away from their responsibilities in another EU country.”