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Latvia's Successful Recovery Not Easy to Replicate

Lumber for export in Skulte, Latvia, which has highest rate of economic growth in European Union and falling unemployment (photo: EPA/AFI/Newscom)

LATVIA CONFERENCE

Latvia's Successful Recovery Not Easy to Replicate

IMF Survey online

June 11, 2012

  • Latvia's economic recovery shows importance of ownership, commitment
  • Euro adoption will be next big challenge
  • More reforms needed to ensure sustainable, inclusive growth

As the euro area continues to struggle with high levels of sovereign debt and elevated stress in financial markets, some members of the European Union have managed to overcome deep recessions and rebuild confidence in their economies.

In the Baltics, Latvia was hit particularly hard by the global economic crisis, suffering a combined GDP decline of almost 25 percent and unemployment surging from 6 percent to 21 percent. Today, Latvia’s just over 2 million people have seen their economy grow at 6.8 percent in the first quarter of 2012, the fastest pace in the European Union. Unemployment, while still unacceptably high, is declining, and now stands at 16 percent. How did Latvia do it? And does its experience hold lessons for the crisis-stricken economies on the eurozone periphery?

“Latvia decided to bite the bullet. Instead of spreading the pain over many years, you decided to go hard, and to go quickly. The achievements were incredibly impressive,” IMF Managing Director Christine Lagarde told the Latvian authorities and more than 400 participants at a June 5 conference titled “Against the Odds—Lessons from the Recovery in the Baltics,” jointly organized by the IMF and the central bank of Latvia.

While Latvia’s “tour de force” sets an example for other European governments struggling to reduce national debt and get out of recession, Lagarde said the country—as well as neighboring Lithuania and Estonia—still need to make structural changes.

“Regardless of whether or not they join the euro, all three Baltic countries need to continue to implement the reforms necessary to make sure they can thrive under a fixed exchange rate. These reforms include raising labor productivity and boosting competitiveness to put them on a permanent path of higher growth and more inclusive growth.”

Keeping the peg

When Latvia first sought financial assistance from the IMF and its partners in the European Union, many economists were skeptical about the government’s decision to keep the peg to the euro. The level of fiscal consolidation that would be needed would almost inevitably plunge the economy into a severe recession, and it seemed as if devaluation would be a less painful way of engineering a recovery.

IMF chief economist Olivier Blanchard told the conference he was among those who had been skeptical that adjustment could succeed without a devaluation, and he had to recognize he had been wrong. He also explained why the IMF went along with the peg: “Programs are a partnership. When we saw that there was a very strong will to keep the peg and a commitment to do whatever was needed to succeed, this not only on the part of Latvia, but also of the European Union and the Nordic countries, we thought: ‘Okay, let’s give it a try,’ ” he said.

Latvia’s European partners, who provided about two-thirds of the €7.5 billion international support package, feel vindicated. “Latvia has shown that this kind of economic adjustment is possible without currency devaluation, which has been also the case in Estonia and Lithuania,” said Olli Rehn, Vice-President of the European Commission.

Tough adjustment

In the first year of its program, Latvia implemented fiscal adjustment of more than 8 percent of GDP. Total adjustment for the whole program was even higher, at around 15 percent of GDP. While the result was a deep recession, Latvia restored confidence and successfully returned to international capital markets, issuing two eurobonds since mid-2011.

Blanchard noted that, while, from a purely economic viewpoint, a slower pace of fiscal adjustment would probably have been preferable, the Latvian experience made a strong case for frontloading before fatigue set in.

Others were even more forceful. “The Baltic experience shows that speed is of the essence when it comes to fiscal consolidation,” Jörg Asmussen, Executive Board member of the European Central Bank, said. “This is undoubtedly an important factor that explains the different trajectories of the Baltics and certain southern European countries.”

The government itself had little doubt that upfront fiscal consolidation was the right path to follow. “Restoration of financial stability is a precondition for economic growth, because once you restore financial stability, banks start lending, people stop worrying, businesses stop worrying, capital is not fleeing the country, probably capital is starting to flow into the country again, so all the process is helping to enable to return to growth,” Latvia’s Prime Minister Valdis Dombrovskis said.

“I’m against austerity. But if you say that you are against austerity, you should also answer the question, okay, who’s going to finance your budget deficit? And in the case of Latvia, financial markets clearly were not in the mood to finance the budget deficit,” he added.

Adopting the euro

A big challenge for Latvia now is to meet the criteria for euro adoption. The country is close to fulfilling the conditions, but is struggling to bring down inflation to the required level. “Latvia is not yet fulfilling all the convergence criteria,” Asmussen said, referring to the most recent convergence report published by the European Central Bank.

“If the European Union says that Latvia cannot join the eurozone, then tell me which country is capable of doing so,” Swedish Finance Minister Anders Borg said.

For his part, Rehn joked he was glad that “Latvia is considering an entry strategy rather than an exit strategy to the euro.” But he saw Latvia’s achievements “as rather a beginning of a longer journey to what’s a sustainable economy model, which can be turned into a long lasting success…This is a critical aspect also from the point of view of possible euro adoption, and, of course, for the economic welfare and social justice in Latvia itself.”

Sharan Burrow, General Secretary, International Trade Union Confederation, questioned the social cost of aiming for euro adoption at all cost. “It may be a terrific ambition to join the euro, but for what?” she asked. “If you’ve still got more than 27 percent of people right here in Latvia who are severely in poverty, materially deprived. If you’ve got 10 percent of your population leaving the country because they’ve got no hope, if wages during these measures fell by 19 percent on average, then how do you boost domestic demand?”

Lagarde also noted the importance of social cohesion and protecting the most vulnerable. “There is an urgent need to create jobs—for young people, for the long-term unemployed, for those nearing retirement age who will find it difficult to retrain. A greater push to reduce inequality would also help a lot…This means smarter investment in education, a move towards more progressive taxation, and a stronger—but well targeted—social safety net,” she said.

Lessons

So can Latvia’s tough recovery strategy be replicated elsewhere, including in crisis-stricken Greece? On that, the jury is still out. A number of speakers pointed out that many of the factors that facilitated adjustment in the Baltics are not present elsewhere in Europe.

According to Lagarde, the most important factor in Latvia’s success was the determination and ownership that the government demonstrated. “At a very basic level, everybody knew what needed to be done. They understood that the huge spike in spending in the years leading up to the crisis could not be sustained,” she said.

The case of Latvia also shows how strong internal commitment can go hand-in-hand with strong external support, as the international community rallied to help the country get back on its feet.

“But what really made it work was the high level of ownership—this was your program, your objectives, your future on the line. Our role was simply to help,” Lagarde told the audience in Riga.


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