Latvia’s Economic Potential: Recovery and Reforms
IMF Blog, January 28, 2013
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- Authors: David Moore
- Published: January 28, 2013
Economic recovery
- Author: David Moore
- Date: January 28, 2013
- Latvia returned to strong economic growth after a severe downturn in 2008 and 2009 and a tough austerity program.
- In late 2012, Latvia repaid the IMF in full, several years early.
- Critics highlight continuing high rates of unemployment and poverty; advocates highlight benefits of frontloading spending cuts and tax increases to lay the foundations for recovery.
- Unemployment surged to over 20 percent in 2008–2009; poverty rates remain high by EU standards.
- IMF stance: consistent case for a strong social safety net in Latvia.
Severe downturn, then steady recovery
- Latvia’s pre-crisis performance (2004–2007):
- Real GDP growth averaging 10 percent annually.
- Credit flowed freely and asset prices boomed.
- Average wage growth reached 20 to 30 percent annually, far outrunning productivity.
- Headline fiscal deficit stayed low but structural fiscal position weakened.
- Massive current account deficits of over 20 percent of GDP in 2006 and again in 2007.
- Country-specific facts affecting crisis response:
- Latvia’s financial system was already very highly “euroized”: some 70 percent of bank deposits and nearly 90 percent of loans were in foreign currency, mainly euros, when Latvia requested its EU-IMF loan in 2008.
- The crash came first, and then the fiscal austerity. The output collapse of 2008 and 2009 ran most of its course already in the first half of 2009; the massive fiscal consolidation effort began in earnest only in the second half of 2009, with the supplementary budget approved in June 2009.
- Policy response:
- Latvia stuck to the long-standing exchange rate peg to the euro.
- Implemented a fiscal adjustment of over 15 percentage points of GDP.
- Post-crisis status:
- External and structural fiscal imbalances have been brought back under control.
- Euro adoption consideration: “We will know in coming months whether Latvia will qualify to adopt the euro in 2014.”
- Latvia is described as stable again.
- Unemployment rate has fallen to between 13–14 percent: well down from the peak, but still high even allowing for emigration.
Sustaining the recovery
- Three questions posed by the IMF paper:
- Is Latvia’s economic activity back in line with its potential? Is still-high unemployment structural or cyclical?
- After years of economic policy discipline and reform efforts, what further microeconomic reforms could support sustainably higher growth?
- Output and unemployment findings:
- Latvia still has a negative output gap of about 2½ percent of potential output.
- Before the crisis: overheating with a positive output gap of up to 10 percent.
- Crisis trough in 2009: slump with a negative output gap of some 13 percent.
- Estimated non-accelerating inflation rate of unemployment (NAIRU) at around 12–13 percent.
- Analysis finds the NAIRU would have been fairly steady over the past few years, even taking into account some hysteresis in 2011 and 2012.
- Conclusion: the high level of unemployment in Latvia is largely structural, although the increase in unemployment through the crisis was largely cyclical.
- Contextual note: when the unemployment rate fell below 6 percent in 2007, it was unsustainable because the economy was badly overheating.
Policy priorities and reforms
- Sectoral reforms highlighted as most productive:
- Improving the efficiency of the legal system, including curbing abuses of the insolvency procedures.
- Improving governance and transparency of state-owned enterprises.
- Upgrading the quality of vocational and higher education.
- Implementation emphasis:
- Authorities recognize the case for reform in these areas and are planning accordingly, but implementation largely lies ahead.
- From the perspective of higher growth, employment, and living standards, implementation will matter most.
- Expected effects of reforms:
- A more efficient legal system would improve the business environment and promote investment.
- An education sector that better responds to the needs of employers would boost productivity and reduce skills mismatches.
- Tax-benefit reforms could promote incentives to work, consistent with a safety net that adequately protects the poorest—an IMF concern throughout the program.
- Policy framing:
- Shift attention from how the crisis was managed to how Latvia can promote economic growth in the future—growth not fueled by fiscal or financial doping, but underpinned by quality microeconomic reforms whose results can endure.
Source: Latvia’s Economic Potential: Recovery and Reforms — David Moore, January 28, 2013.
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