Latvia Beat the Odds—But the Battle Is Far From Over

IMF Blog, June 1, 2012

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Latvia, a nation of about 2.2 million people bordering the Baltic Sea, experienced the most extreme boom-bust cycle among emerging market countries of Europe.
In December 2008 Latvia agreed to a tough economic program with the IMF and the European Union.
Despite doubts, Latvia successfully completed its IMF-supported program in December 2011.
The author worked closely with Latvian authorities over the past three years in the capacity of IMF mission chief.

Real GDP grew by 5½ percent in 2011, and is projected to expand by 3½ percent in 2012.
Latvia has returned to international capital markets: it has issued two eurobonds since mid-2011 and is now rated at investment grade.
Remaining economic and social challenges:
- Unemployment remains unacceptably high at more than 15 percent.
- Considerable migration: some estimates suggest as many as 200,000 people (just under one tenth of the population)—mainly the young and educated—have left Latvia over the past decade.
- Latvia remains one of the poorest and most unequal countries in the EU.

Adopting the euro was the program’s exit strategy and provided a strong anchor for policy discipline.
Expected benefits of adopting the euro:
- remove exchange rate risk—particularly for borrowers (90 percent of loans are currently denominated in foreign currency)
- reduce interest rates for both the public and private sector
- increase Latvia’s integration into the single market
Risks and policy implications:
- New uncertainties surround the euro, making continued fiscal discipline important.
- Adopting the euro implies limits on exchange rate adjustment; Latvia will need to focus on improving competitiveness to adjust within a currency union.

With a fixed exchange rate or common currency, improving competitiveness is the only viable way to create new jobs.
Structural reform priorities to promote productivity growth in the traded goods sector:
- increasing labor productivity by improving the quality of education
- strengthening the investment climate
- increasing product market competition to ensure that productivity gains translate into an overall improvement in competiveness
Fiscal policy must remain disciplined; the proposed Fiscal Discipline Law is cited as a positive step.

Starting conditions for inclusive growth:
- Income levels are only about half the EU average.
- Income inequality is one of the highest in the EU.
- Unemployment rose from 6 to 21 percent during the crisis, and is still high at more than 15 percent.
- As a percent of GDP, Latvia only spends half the EU average on social programs.
Social policy measures encouraged during the IMF-supported program (in cooperation with the World Bank and the European Commission):
- expand and improve the targeting of social assistance
- extend the duration and coverage of unemployment benefits
- increase health benefits for the poor
Job-creating policies supported under the program:
- on-the-job training programs
- public works programs such as the “100 Lats” program (a workplace-with-stipend program which pays L100 or €140 per month)
Post-program advice:
- continue to strengthen the social safety net by improving incentives to work and ensuring social benefits are targeted to those who need them most.

The recovery demonstrates that adjustment under a fixed exchange rate is possible but was painful, with a huge decline in output and increased unemployment and hardship.
Latvia’s experience will be discussed at a conference titled “Against the Odds—Lessons from the Recovery in the Baltics,” jointly organized by the IMF and the Bank of Latvia, featuring Latvian Prime Minister Valdis Dombrovskis, IMF Managing Director Christine Lagarde, IMF Chief Economist Olivier Blanchard, EU Commissioner Olli Rehn, Jörg Asmussen of the European Central Bank, and Giancarlo Corsetti from Cambridge University.

Source: Latvia Beat the Odds—But the Battle Is Far From Over (IMF blog post, June 1, 2012).