The document discusses Latvia's experience during the 2008 financial crisis and recovery. It explains that Latvia chose an internal devaluation through austerity and structural reforms rather than devaluing its currency. This led to a rapid but difficult adjustment period and a "V-shaped" economic recovery. Key factors in Latvia's success included speed of implementation, ownership of reforms, commitment to change, and national solidarity. The internal adjustment approach stabilized public finances, restored competitiveness and exports, attracted foreign investment, and put Latvia in a strong position to adopt the Euro in 2014.

1. Lessons from Latvia’s internal
adjustment
Ilmārs Rimšēvičs
Governor of the Bank of Latvia
March 1, 2012

2. Origins of the recent Crisis?
The past growth was fuelled by massive capital inflows,
building up excessive demand and a real estate bubble
Bank of Government Commercial Labour
FDI EU Funds
Latvia budget Banks remittances
1 EUR = 0.702804 LVL

3. Labour market overheated significantly, driving
wages above productivity and hurting competitiveness
Wages and productivity, 2000=100
200
190
180
170
160
150
140
130
120
2004 2005 2006 2007 2008
Productivity Real wage
Source: CSB, Bank of Latvia staff calculations

4. Excessive demand showed up in massive
current account deficits
Current account balance, % of GDP
0.0
-5.0 -6.7
-8.2
-10.0 -12.9 -12.6
-15.0
-20.0
-22.6 -22.4
-25.0
2002 2003 2004 2005 2006 2007
Source: Bank of Latvia

5. GDP was pushed up by banks borrowing abroad and
channelling funds into economy to nurture massive lending
boom, until the bubble collapsed
Credit to residents, % y-o-y
70
+60.4
60
50
40
30
20
10
0
-8.2
-10
I 2011
I 2004
I 2005
I 2006
I 2007
I 2008
I 2009
I 2010
I 2012
Source: Bank of Latvia

6. Latvia at the outset of the recent crisis
Many suggested devaluation as a
way out of the crisis.
Why devaluation was not an
appropriate solution?

7. Devaluation is not a solution for Latvia
 High import content in exports and domestic produc-
tion, competitive gains reduced by surge in input costs
 No immediate improvement in the current account
(Marshall-Lerner condition is not met)
 High share of FX liabilities: many corporates would
face negative equity immediately
 Loss of credibility and likely run on banks
 Court system unable to cope with sharp increase in
insolvency cases, inefficient insolvency procedure
 No motivation to improve efficiency and productivity

8. The internal adjustment was the only path to
follow
 Time bought for structural reforms that
smoothen adjustment
 Improvement of public sector efficiency
 Less corporate bankruptcies reduce costs for the
economy
 More gradual adjustment motivates businesses for
productive improvements
 Latvia’s economy is reasonably flexible to adjust
 Society understands the root causes of crisis and
supports necessary austerity and reforms

9. Despite loud ex ante warnings of protracted
recession risks under internal adjustment scenario,
a strong “V” shaped recovery followed
Real GDP growth, %
15
10
5 5.3
0
-5
-10
-15
-20
2006 2007 2008 2009 2010 2011F
Source: CSB; F – Bank of Latvia forecast

10. Latvia has implemented sizable fiscal consolidation
underpinned by structural reforms
Breakdown of budget consolidation measures, % of GDP
Source: Ministry of Finance; Bank of Latvia staff calculations

11. Indeed, Latvia and other Baltic countries have clearly
benefited from getting through the internal adjustment at
an early stage
GDP growth in 2011, % y-o-y
8.0
6.0
4.0
2.0
0.0
-2.0
-4.0
Latvia
Sweden*
Ireland*
Cyprus
Spain
France
Slovenia*
Poland*
Greece*
Italy*
Hungary
Portugal*
Bulgaria*
Austria
Lithuania
Slovakia
Netherlands
Malta*
Finland
Belgium*
UK*
Czech Rep.*
Estonia
Romania*
Luxembourg*
Germany
Denmark*
Source: Eurostat; * - EC Interim Forecast (February 2012) for those countries, whose GDP data is not yet available for the year as a whole

12. How Latvia managed to accomplish what initially was
claimed being impossible?
 Speed
 Ownership
 Commitment
 Solidarity

13. 0
5
-5
10
15
20
Estonia
Source: Eurostat
Lithuania
Czech Republic
Latvia
Romania
Slovakia
Bulgaria
Spain
Hungary
Sweden
Germany
Slovenia
Austria
Denmark
Italy
Portugal
Poland
Belgium
United Kingdom
France
Netherlands
Cyprus
Ireland
Luxembourg
Iceland
Finland
Greece
Latvia ranges among the export leaders in Europe
Exports already well above the pre-crisis peak level;
Real growth in exports of goods and services, first three quarters of 2011, % y-o-y
Malta

14. Recovery was largely underpinned by regained
competitiveness: wage-productivity gap has been closed
Real hourly wage and labour productivity per hour (seasonally adjusted), 2005 Q1 = 100
150
140
130
120
110
100
90
80
Q3
Q3
Q3
Q3
Q3
Q3
Q3
Q3
2004 Q1
2005 Q1
2006 Q1
2007 Q1
2008 Q1
2009 Q1
2010 Q1
2011 Q1
Labour productivity Real wage
Source: CSB; Bank of Latvia staff calculations

15. Export market shares increase is among the strongest in
the group of new EU member states
Latvia’s merchandise export shares in world export, 2002=100
220
210 Bulgaria
200 Czech Republic
190
Estonia
180
170 Hungary
160 Latvia
150
Lithuania
140
130 Poland
120 Romania
110
Slovakia
100
Slovenia
90
2002 2003 2004 2005 2006 2007 2008 2009 2010 Q1 Q2 Q3
2011
Source: WTO

16. External imbalances have been corrected quickly:
current account remains close to balance
Balance of Payments, % of GDP
15.0
8.6
10.0
5.0 3.0
-0.5 -0.6
0.0
-5.0
-10.0
-15.0
-13.1
-20.0
-25.0 -22.6 -22.4
2006 2007 2008 2009 2010 2011F 2012F
Goods and services Income Current transfers Current account
Source: Bank of Latvia; F – Bank of Latvia forecast

17. Latvia has regained investor confidence
Net FDI inflows, mln LVL (ex banking and real estate, moving average)
160.0
Net FDI inflows in 2011:
140.0
5.8% of GDP
120.0
100.0
80.0
60.0
40.0
20.0
0.0
-20.0
-40.0
IV
II
IV
II
IV
II
IV
II
IV
II
IV
II
II
IV
II
III
III
III
III
III
III
III
III
I 2005
I 2011
I 2004
I 2006
I 2007
I 2008
I 2009
I 2010
IV*
Source: Bank of Latvia; * - preliminary data

18. In contrast to countries that responded to crisis by
devaluing and imposing capital controls, Latvia has
experienced a strong rebound in investment
Gross fixed capital formation, % y-o-y
40
28.6
30 24.4
21.9
20
10
0
-10
-20
-30
-40
-50
IV
IV
II
IV
II
II
IV
II
II
III
III
III
III
III
I 2008
I 2007
I 2009
I 2010
I 2011
Source: CSB

19. With sizeable fiscal adjustment budget balance is
expected to reach sustainable levels
General Government balance (ESA’95), % of GDP
0 -0.4 -1.0 0.0
-2.5
-2 -4.0
-4.2
-4 -8.3
-9.7
-6
-8
-10
-12
-14
-16
-18
-20
2007 2008 2009 2010 2011 2012F 2013F 2014F
Consolidation effort Actual (targeted) balance
Source: Eurostat, BoL staff estimation

20. Public debt has stabilized at around 45% of GDP; well
below initially expected peak of close to 100% of GDP
General government gross debt (ESA95), % of GDP
60
50
40
30
20
10
0
2007 2008 2009 2010 2011F 2012F
Source: Eurostat; F -Bank of Latvia forecast

21. Current forecast scenario implies that Latvia
is expected to comply with the Maastricht inflation
criteria since the beginning of 2013
Maastricht criteria estimate forecast and 12 month average inflation, %
5
4
3
2
1
0
Maastricht criteria*
-1
-2 12 month average inflation
-3
I 2010 IV VII X I 2011 IV VII X I 2012 IV VII X I 2013 IV VII X
Source: CSB, EC autumn 2011 forecast; Bank of Latvia forecasts and staff calculations

22. The aim of introducing Euro in 2014
is well within reach
General Government budget balance (ESA95), % of GDP
0.0
0.0
-1.0 -0.4
-1.0
-2.0
-3.0
-2.5
-4.0
-4.2 -4.0
-5.0
-6.0
EURO
-7.0
-8.0
-9.0 -8.3
-10.0 Budget strategy Measure-
-9.7
-11.0
ment
-12.0
2007 2008 2009 2010 2011 2012F 2013F 2014F
Source: Eurostat, BoL staff estimation

24. Many European countries still suffer from weak public
finance discipline
Budget balance, % of
Public debt, % of GDP* GDP growth, % Inflation, %
GDP*
2011 2012 2011 2012 2011 2012 2011 2012
Greece 162.8 198.3 -8.9 -7.0 -6.8 -4.4 3.1 -0.5
Italy 120.5 120.5 -4.0 -2.3 0.2 -1.3 2.9 2.9
Ireland 108.1 117.5 -10.3 -8.6 0.9 0.5 1.2 1.6
Portugal 101.6 111.0 -5.8 -4.5 -1.5 -3.3 3.6 3.3
Belgium 97.2 99.2 -3.6 -4.6 1.9 -0.1 3.5 2.7
Euro area 88.0 90.4 -4.1 -3.4 1.4 -0.3 2.7 2.1
France 85.4 89.2 -5.8 -5.3 1.7 0.4 2.3 2.2
EU 82.5 84.9 -4.7 -3.9 1.5 0.0 3.1 2.3
Germany 81.7 81.2 -1.3 -1.0 3.0 0.6 2.5 1.9
Austria 72.2 73.3 -3.4 -3.1 3.1 0.7 3.6 2.4
Spain 69.6 73.8 -6.6 -5.9 0.7 -1.0 3.1 1.3
Malta 69.6 70.8 -3.0 -3.5 2.1 1.0 2.4 2.1
Cyprus 64.9 68.4 -6.7 -4.9 0.5 -0.5 3.5 2.8
Netherlands 64.2 64.9 -4.3 -3.1 1.2 -0.9 2.5 2.0
Finland 49.1 51.8 -1.0 -0.7 2.7 0.8 3.3 3.0
Slovenia 45.5 50.1 -5.7 -5.3 0.3 -0.1 2.1 1.6
Slovakia 44.5 47.5 -5.8 -4.9 3.3 1.2 4.1 1.9
Luxembourg 19.5 20.2 -0.6 -1.1 1.1 0.7 3.7 2.7
Estonia 5.8 6.0 0.8 -1.8 7.5 1.2 5.1 3.1
* - marked = non compliance with Maastricht criteria
Source: EC Autumn 2011 forecasts (public finance data), EC February 2012 forecasts (GDP and inflation)