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

Latvia, a nation of about 2.2 million people bordering the Baltic Sea, went through the most extreme boom-bust cycle of the emerging market countries of Europe, and was among the first to ask for financial assistance from the international community.

Back in the dark days of December 2008, many doubted that Latvia—which joined the European Union in 2004 together with its Baltic neighbors Estonia and Lithuania—would be able to stick to the tough economic program it had just agreed with the IMF and the European Union. But it did. Against the odds, it successfully completed its IMF-supported program in December 2011.

Over the past three years, I have worked closely with the Latvian authorities in my capacity as IMF mission chief. Worked with them—but learnt from them too.

A successful comeback

Today, Latvia is one of the fastest growing economies in the European Union. Real GDP grew by 5½ percent in 2011, and is now projected to expand by 3½ percent in 2012, a number that possibly will come out even higher.

Latvia has also successfully returned to international capital markets. It has issued two eurobonds since mid-2011, and is now rated at investment grade. The turnaround has been incredible.

Of course, there is more to be done. It’s no longer “Mission Impossible”—but it’s also too soon to say “Mission Accomplished.” Latvia is still one of the poorest and most unequal countries in the EU, and unemployment remains unacceptably high at more than 15 percent. There has been 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 for opportunities elsewhere.

So what are the remaining challenges? I see three main ones:

  • Meeting the criteria for joining the euro in 2014
  • Staying competitive within the eurozone
  • Developing a strategy to make growth more inclusive.

Meeting the criteria and joining the euro

From the start, adopting the euro was the program’s exit strategy. This gave economic policy a strong anchor, and helped the government stick to the program. Adopting the euro would:

  • 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

It’s true that the euro now faces new uncertainties—ones that, it’s fair to say,  we hadn’t anticipated when the program was drawn up. But these uncertainties only make it more important for Latvia to stick to its record of fiscal discipline so that its economy can continue to flourish.

Adopting the euro of course also implies challenges, just like under the fixed exchange rate. While Latvia’s recent record shows it is ready to adjust within a currency union, it will need to focus on continuing to improve its competitiveness. This brings me to what I see as the second main challenge.

Growing within the euro area

To avoid the fate of the crisis-hit countries in the eurozone periphery, Latvia will have to stay nimble once it adopts the euro. In a context where the exchange rate cannot be devalued, improving competitiveness is the only viable way to create new jobs. And that can only be achieved through structural reforms that promote productivity growth in the traded goods sector.

Key challenges include:

  • 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
  • To survive under a fixed exchange rate or common currency, fiscal policy will also need to remain disciplined. Here, the proposed Fiscal Discipline Law is a good step in the right direction.

Making growth inclusive

To improve the welfare of its citizens, Latvia needs growth but, above all, inclusive growth. The starting level is not good. Income levels are only about half the EU average, and 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. And yet, as a percent of GDP, Latvia only spends half the EU average on social programs.

To compensate for the increase in hardship caused by wage and job cuts, the IMF—working with the World Bank and the European Commission—encouraged measures under the program to expand and improve the targeting of social assistance. Measures included extending the duration and coverage of unemployment benefits, and increasing health benefits for the poor.

The program also strongly supported job-creating policies, including on-the-job training programs and public works programs such as the “100 Lats” program (a workplace-with-stipend program which pays L100 or €140 per month).

After the program ended, the IMF has continued to encourage the government to strengthen the social safety net by improving incentives to work and ensuring social benefits are targeted to those who need them the most.

In sum

The recovery in Latvia demonstrates that adjustment under a fixed exchange rate is possible. But the huge decline in output, and increase in unemployment and hardship, also tells us beyond any doubt that adjustment has been painful.

Latvia’s experience will be discussed at a conference titled “Against the Odds—Lessons from the Recovery in the Baltics.”

The conference, jointly organized by the IMF and the Bank of Latvia, will see the likes of 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 debate whether the lessons from the recovery in the Baltics are applicable elsewhere, including in the crisis-stricken countries in the eurozone.