Extract 3 imf praise for Latvia

1. Extract
3:
IMF
praise
for
fiscal
austerity
in
Latvia
Latvia
is
one
of
the
featured
countries
in
the
June
2014
Case
Study.
Click
here
for
BBC
Country
Profile
• Latvia
is
one
of
the
Baltic
States
–
the
others
are
Estonia
and
Lithuania
• It
is
a
small
country
with
a
total
population
of
just
over
two
million
people.
• Globally
it
procures
only
0.05%
of
world
output
of
goods
and
services
• It
is
also
small
in
a
European
Union
context
but
Latvia
is
a
highly
open
economy
with
trade
accounting
for
a
large
share
of
GDP
• All
three
Baltic
States
countries
joined
the
European
Union
in
May
2004
as
part
of
the
largest
enlargement
that
the
EU
single
market
has
ever
seen
• On
1st
of
January
2014,
Latvia
joined
the
single
European
currency
–
the
18th
country
to
join
Selection
of
basic
statistics
on
the
Latvian
economy
(Sources:
OECD
World
Economic
Outlook,
World
Economic
Forum,
BBC,
IMF
and
World
Trade
Organisation)
• Population
(thousands,
2012):
2,025
–
there
is
a
large
Russian
ethnic
minority
• The
Latvia
population
is
declining
-­‐
Between
2000
and
2011;
the
population
fell
by
about
13%.
• GDP
(million
current
US$,
2012):
$28,324
• GDP
(million
current
PPP
US$,
2012):
$42,471
• Current
account
balance
(million
US$,
2012):
-­‐$473m
• Trade
to
GDP
ratio
(2010-­‐2012):
117.8%
• GDP
(PPP)
as
share
(%)
of
world
total:
0.05
• National
minimum
wage
for
Latvia:
200
lats
(£237;
284
Euros;
$392)
per
month
Breakdown
of
total
Latvian
exports
(2012)
1. European
Union
(27):
68.8
2. Russian
Federation:
11.4
3. Norway:
2.6
4. Algeria:
2.1
5. Belarus:
1.8
Breakdown
of
total
Latvian
imports
(2012)
1. European
Union
(27):
77.3
2. Russian
Federation:
9.4
3. Belarus:
3.6
4. China:
2.8
5. Ukraine:
1.4

2. International
competitiveness
ranking
• Global
Competitiveness
Index
(2013):
52
out
of
148
countries
• Latvia
scored
highly
for
ease
of
doing
business
=
the
government
has
followed
pro-­‐private
sector
policies
in
recent
years
Focus
on
Latvia’s
Exchange
Rate
and
Balance
of
Payments
Extract
In
December
2008
the
IMF
announced
plans
to
lend
€1.7
billion
to
Latvia
to
help
to
stabilise
its
economy.
This
financial
assistance
was
supplemented
by
loans
from
the
European
Union
(EU),
the
World
Bank
and
several
Nordic
countries
to
provide
a
package
totalling
€7.5
billion.
The
assistance
was
part
of
an
agreement
to
defend
Latvia’s
currency
peg
to
the
euro
(a
fixed
exchange
rate)
and
the
country’s
commitment
to
join
the
euro.
The
Latvian
currency,
the
lat,
had
come
under
pressure
as
a
result
of
a
current
account
deficit
on
the
balance
of
payments
of
almost
25%
of
GDP
in
2007.
This
deficit
was
financed
by
increasing
levels
of
private
sector
external
debt.
The
credit
and
growth
boom
that
followed
Latvia’s
accession
to
the
EU
simply
could
not
be
sustained.
Very
high
wage
growth,
far
in
excess
of
productivity
growth,
had
severely
undermined
Latvia’s
international
competitiveness
and
contributed
to
the
economy’s
large
external
imbalances.
Latvia
was
once
the
fastest
growing
economy
in
the
EU.
By
the
end
of
2008
it
was
the
worst-­‐performing
economy.
What
is
meant
by
a
currency
peg
to
the
Euro?
• A
currency
peg
is
an
announced
fixed
exchange
rate,
normally
against
a
major
currency
like
the
Euro
or
the
US
dollar,
but
also
sometimes
against
a
basket
of
currencies.
•
From
January
2005
onwards
the
Latvian
lat
was
pegged
at
1.43
lats
to
the
euro.
• The
lat
was
left
to
float
against
the
US
dollar
prior
to
Latvia
joining
the
Euro
in
January
2014.
• A
currency
peg
is
maintained
through
intervention
in
the
currency
markets
by
a
central
bank.
How
can
a
central
bank
maintain
a
currency
peg?
If
a
currency
is
under
strong
selling
pressure,
then
the
central
bank
might
decide
to:

3. 1. Raise
domestic
policy
interest
rates:
Increasing
interest
rates
will
lift
the
expected
return
to
short
term
flows
of
capital
coming
into
the
country’s
banking
system.
Other
things
being
equal,
an
influx
of
“hot
money”
will
cause
an
outward
shift
in
demand
for
the
currency
and
an
appreciation
of
the
exchange
rate
–
helping
to
maintain
the
currency
peg.
2. Direct
intervention:
The
central
may
also
go
into
the
currency
market
and
intervene
directly
by
buying
up
their
own
currency
(e.g.
the
Latvian
lat)
and
selling
others
(e.g.
the
Euro).
This
is
why
countries
that
want
to
stabilise
the
external
value
of
their
currency
often
have
to
maintain
quite
high
reserves
of
foreign
currencies
so
that
intervention
–
if
and
when
it
happens
–
can
be
effective.
3. Legal
controls:
Another
option
–
but
one
rarely
used
–
is
for
a
government
to
declare
a
fixed
exchange
rate
and
make
it
illegal
for
foreign
trade
in
goods
and
services
to
take
place
at
any
other
announced
exchange
rate.
The
main
difficulty
with
this
is
that
is
naturally
encourages
black
markets
to
emerge
with
unofficial
exchange
rates
for
many
transactions.
As
part
of
their
currency
peg
against
the
Euro,
the
Latvian
central
bank
held
foreign
exchange
reserves
to
back
every
lats
in
circulation
–
so
that
there
was
a
sufficient
buffer
stock.
The
end
result
was
a
strong
surge
in
Latvia’s
foreign
exchange
reserves.
The
value
of
the
Latvia
currency
against
the
Euro
is
shown
in
our
next
chart
below.
Daily exchange rate for the Lat against the Euro
Latvian Currency v The Euro
Source: International Monetary Fund
02 03 04 05 06 07 08 09 10 11 12 13 14
0.550
0.575
0.600
0.625
0.650
0.675
0.700
0.725
EUR/LVL
0.550
0.575
0.600
0.625
0.650
0.675
0.700
0.725

4. • The
currency
peg
system
against
the
Euro
was
in
place
for
nine
years
from
January
2005
through
to
Latvian
accession
to
the
Euro
in
January
2014.
In
January
2009
for
example,
1
EUR
=
0.702804
LVL
i.e.
one
lat
was
worth
around
Euro
1.42
• Basically
the
lats
was
a
fixed
exchange
rate
against
the
Euro
over
this
period
–
the
currency
peg
was
maintained,
although
when
the
global
financial
crisis
engulfed
Latvia
and
many
other
countries,
there
was
strong
pressure
on
the
country
to
end
their
peg
and
allow
a
devaluation
of
the
Lats
by
perhaps
25%
or
more.
• A
key
point
to
remember
is
that,
although
the
lats/euro
exchange
rate
was
fixed,
the
euro
itself
was
floating
in
global
currency
markets.
So
that
any
fall
in
the
Euro
against
the
US
dollar
or
the
British
pound
for
example
would
bring
about
a
similar
depreciation
of
the
lats.

5. Analyse
how
a
current
account
deficit
can
put
the
external
value
of
a
currency
under
pressure
A
current
account
deficit
happens
when
a
country
is
running
a
net
deficit
in
trade
in
goods
and
services,
net
investment
income
and
net
transfers.
It
represents
a
net
outflow
from
the
circular
flow
of
income
and
spending,
and
a
net
outflow
of
currency
from
the
deficit
country.
This
deficit
can
be
shown
by
an
outward
shift
in
currency
supply
which
–
other
factors
remaining
equal
–
will
put
downward
pressure
on
a
nation’s
currency
value.
Be
able
to
use
a
currency
supply
and
demand
diagram
to
show
this
if
asked
in
the
exam
The
scale
of
Latvia’s
current
account
deficits
in
the
middle
part
of
the
last
decade
was
staggering.
Any
country
running
an
external
deficit
of
more
than
10%
of
GDP
is
often
running
into
trouble,
but
Latvia’s
balance
of
payments
gap
on
the
current
account
far
exceeded
even
this!
The
figures
were
as
follows:
• 2005:
-­‐12.9%
of
GDP
• 2006:
-­‐12.5%
of
GDP
• 2007:
-­‐22.5%
of
GDP
• 2008:
-­‐22.3%
of
GDP
• 2009:
-­‐13.1%
of
GDP
• 2010:
+8.6%
of
GDP
Note
here
the
dramatic
turnaround
in
Latvia’s
current
account
between
2009
and
2010
How
is
a
current
account
deficit
financed?
• A
current
account
deficit
essentially
represents
a
negative
balance
of
trade,
investment
income
and
transfers
between
once
country
and
the
rest
of
the
world.
• The
current
account
of
the
Balance
of
Payments
can
also
be
expressed
as
the
difference
between
national
(both
public
and
private)
savings
and
investment.
A
current
account
deficit
may
therefore
reflect
a
low
level
of
national
savings
relative
to
investment
or
a
high
rate
of
investment—or
both.
In
Latvia’s
case
the
current
account
deficit
was
the
direct
consequences
of
an
unsustainable
borrowing
boom
much
of
which
was
met
by
a
surge
in
imports.
• A
current
account
deficit
is
financed
by
the
deficit
country
attracting
foreign
capital.
It
needs
to
attract
a
large
net
inflow
of
capital
from
overseas
in
order
to
balance
the
accounts
as
a
whole.
Where
does
this
foreign
capital
come
from?
There
are
plenty
of
alternatives
but
much
will
depend
on
the
economy
itself
–
including
the
stage
of
development,
the
attractiveness
of
an
economy
to
inward
investment
and
the
strength
and
stability
of
institutions
such
as
banks,
bond
markets
and
stock
markets.
Foreign
capital
might
come
in
from:

6. 1. Inflows
of
portfolio
investment
into
equities
(shares),
property
and
bonds
2. Short
term
inflows
of
“hot
money”
into
a
country’s
banking
system
perhaps
attracted
by
relatively
high
interest
rates
available
on
savings
deposits
3. Foreign
direct
investment
projects
such
as
transnational
businesses
launching
capital
investment
projects
or
through
takeover
activity
What
caused
the
credit
and
growth
boom
in
Latvia
after
her
entry
into
the
EU
in
2004?
The
boom
was
in
large
part
the
result
of
Latvia
joining
the
European
Union
in
May
2004.
The
decision
to
go
ahead
with
EU
enlargement
had
been
made
a
few
years
earlier
and
one
effect
of
this
was
a
pre-­‐accession
and
post-­‐accession
boom
in
inward
investment.
Businesses
believed
in
and
saw
opportunities
from
incomes
per
capita
in
Latvia
and
other
Baltic
States
converging
closer
to
average
EU
per
capita
incomes
The
boom
was
also
fuelled
by
lower
interest
rates
on
offer
to
consumers
and
businesses
from
foreign-­‐owned
banks,
and
a
sharp
rise
in
expectations
or
Keynesian
animal
spirits.
Lower
interest
rates
brought
about
a
surge
in
house
prices
and
in
spending
on
consumer
durables.
Consider
the
chart
below
which
tracks
purchases
of
new
cars
in
Latvia.
Keep
in
mind
that
Latvia
does
not
produce
any
cars
of
its
own!
Outline
some
of
the
consequences
of
a
credit
and
growth
boom
such
as
that
experienced
by
Latvia
Latvia, New Passenger Car Registrations
Source: Reuters EcoWin
04 05 06 07 08 09 10 11 12 13
0
500
1000
1500
2000
2500
3000
3500
Numberofnewcarsregisteredpermonth
0
500
1000
1500
2000
2500
3000
3500

7. In
the
short
term,
the
boom
in
real
GDP
growth
fuelled
by
a
money
and
credit
surge
produced
some
positive
effects
for
Latvia.
Unemployment
fell
and
real
living
standards
increased.
But,
like
many
booms
in
other
countries,
this
was
unbalanced
expansion
built
on
the
flimsy
foundations
of
an
asset
price
bubble.
The
consequences
included:
1. Inflation:
A
sharp
increase
in
consumer
prices
inflation
and
a
worsening
of
international
competitiveness.
Remember
that
Latvia
was
operating
a
fixed
currency
peg
against
the
Euro,
so
if
their
inflation
rate
was
higher
than
EU
countries,
the
relative
prices
of
Latvian
products
becomes
more
expensive
2. Bursting
of
the
credit
bubble
and
deep
recession:
The
unsustainable
bubble
in
credit
came
up
against
the
start
of
the
global
financial
crisis
best
described
as
a
sudden
credit
crunch.
Banks
stopped
lending
the
global
slowdown
caused
a
steep
decline
in
exports
from
Latvia.
And
the
economy
fast
descended
into
a
deep
recession
made
worse
by
billions
of
euro
of
bad
debts
in
the
Latvian
banking
system.
The
components
of
the
current
account
for
Latvia
are
shown
in
the
next
chart.
• By
far
the
biggest
cause
of
the
current
account
deficit
was
the
huge
trade
deficit
in
goods.
It
reached
a
monthly
peak
of
nearly
400
million
lats
in
the
summer
of
2007.
• Net
investment
income
for
Latvia
is
negative,
balanced
out
by
net
inflows
of
transfer
payments.
As
one
of
Europe’s
relatively
poorer
countries,
Latvia
is
in
receipt
of
structural
funding
from
the
EU
budget.
And
sizeable
net
outward
migration
from
Latvia
has
meant
that
the
country
also
receives
a
flow
of
remittance
income
from
Latvians
living
and
working
overseas.
• The
country
runs
a
small
but
growing
surplus
in
trade
in
services
• Tourism
is
becoming
an
increasingly
important
source
of
growth
and
foreign
exchange
for
the
country.

8.
Monthly net balances for trade in goods, services, transfers and investment income
Latvia - Balance of Payments - Current Account
Goods Services Income Current Transfers
Source: Reuters EcoWin
05 06 07 08 09 10 11 12 13
millions
-400
-300
-200
-100
0
100
200
300
LatvianLats(millions)
-400
-300
-200
-100
0
100
200
300

9. Focus
on
Competitiveness
Why
does
fast
wage
growth
in
excess
of
productivity
growth
cause
a
fall
in
competitiveness?
The
key
to
this
question
is
to
understand
that
the
basic
measure
of
competitiveness
is
an
index
of
relative
unit
labour
costs
(RULCs).
This
measures
the
labour
cost
per
unit
of
output
and
is
determined
by
two
key
factors
–
namely
the
rate
of
growth
of
wages
and
the
rate
of
growth
of
labour
productivity
(I.e.
output
per
person
employed
or
output
per
person
hour).
Consider
two
simple
numerical
examples:
• If
wages
are
rising
at
6%
per
year
and
labour
productivity
is
growing
by
3%
per
year,
then
unit
labour
costs
will
be
rising
by
3%.
• If
wages
are
rising
at
4%
per
year
and
labour
productivity
is
growing
by
5%
per
year,
then
unit
labour
costs
will
be
falling
by
1%.
A
country
whose
unit
labour
costs
are
increasing
at
a
rapid
rate
risks
losing
price
and
competitiveness
from
year
to
year.
Businesses
who
find
that
their
supply
costs
are
rising
will
be
under
pressure
to
raise
prices
to
protect
their
profit
margins
and
this
can
lead
to
consumers
in
domestic
and
overseas
markets.
Exporters
for
example
may
find
that
they
start
losing
market
share
to
suppliers
in
other
countries
whose
costs
are
not
growing
as
quickly.
The
term
relative
unit
labour
costs
mean
that
we
must
also
consider
what
is
happening
to
unit
labour
costs
in
other
countries.
For
example,
if
unit
labour
costs
are
rising
by
5%in
Latvia
and
only
2%
in
other
EU
countries,
then
Latvia
will
suffer
a
worsening
of
international
competitiveness.
What
is
meant
by
international
competitiveness
and
how
is
it
measured?
International
(or
external
competitiveness)
is
the
ability
to
sell
goods
and
services
at
competitive
prices
in
a
foreign
country.
There
are
two
main
types
of
competitiveness
1. Cost
(price)
competitiveness
–
differences
in
unit
costs
between
producers
–
eventually
reflected
in
the
market
prices
for
goods
and
services
2. Non-­‐price
competitiveness
–
this
encompasses
technical
factors
such
as
product
quality,
design,
reliability
and
performance,
choice,
after-­‐sales
services,
marketing,
branding
and
the
availability
and
cost
of
replacement
parts
When
assessing
competitiveness,
non
cost
factors
include:
• Costs
of
meeting
environmental
/
health
regulations
• Environmental
taxes
e.g.
carbon
taxes
and
waste
taxes
• Employment
protection
laws
and
health
and
safety
laws
• Requirements
to
provide
pensions
for
employees

10. Each
year
the
World
Economic
Forum
publishes
a
detailed
survey
and
ranking
of
countries
in
terms
of
their
overall
competitiveness.
We
will
look
at
this
when
considered
the
competitive
positions
of
Latvia
and
Iceland
later
on
in
this
case
study
toolkit.