Lessons from Latvia

IMF Blog, June 11, 2012

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Author: Olivier Blanchard; Date: June 11, 2012.
From 2005 to 2007, average annual growth had exceeded 10%.
The current account deficit had increased to more than 20% of GDP.
By early 2008 the boom had ended; by the end of 2008:
- output was down by 10% from its peak,
- the fiscal deficit was shooting up,
- capital was leaving the country,
- reserves were rapidly decreasing.

The government chose to keep the currency peg rather than pursue a sharp nominal depreciation because of:
- a commitment to eventually enter the euro,
- fear of balance sheet effects of devaluation on domestic loans (90% denominated in euros).
The IMF-supported program kept the peg and included a strongly front-loaded fiscal consolidation.
Latvian commitment and support from European Union partners were decisive in maintaining the peg.

Subsequent outcomes:
- Four years later, Latvia had one of the highest growth rates in Europe.
- The peg has held.
- The fiscal and current accounts are close to balance.
Mechanics described:
- Initial sharp decrease in output,
- Increases in competitiveness due initially to decreases in wages, increasingly due to productivity gains,
- Growth initially from external demand, increasingly from domestic demand.
Projection qualifier: "Unless Europe has a meltdown, growth should continue."

Output dynamics:
- Output further contracted by 16% in 2009,
- Output is still 15% below its 2007 peak.
Labor market:
- Unemployment increased to more than 20% and still stands at 16% today.
- Concern about long term unemployment effects.
Assessment: The economic and social cost of adjustment has been substantial, but the adjustment looks likely to succeed under the peg.

Preceding boom: the adjustment was seen partly as a return to normal because of the unusually strong boom.
Political and social acceptance:
- Support for fiscal consolidation and acceptance of pain;
- Parties arguing for stronger fiscal austerity often did better at the polls;
- Pedagogy and historical experience (painful transition from central planning) helped acceptance.
Wage flexibility:
- Dramatic reduction in public sector wages improved the fiscal position and put pressure on private sector wages,
- Caveat: private sector wages adjusted much less than public sector wages; nominal wages have started to increase while more adjustment may be needed.
Productivity catch-up potential:
- Latvia has income per capita of half the European Union average, implying substantial room for productivity increases.
Openness of the economy:
- Exports around 50% of GDP, so competitiveness improvements have large effects on imports, exports, and GDP.
Low initial public debt:
- Public debt was very low to start, less than 10% of GDP.
- Even today, public debt remains around 40% of GDP — this helped alleviate foreign investor concerns about sovereign default and facilitated a quicker return to international markets.
Financial sector structure:
- The financial system was largely composed of relatively friendly foreign banks (notably Swedish banks) that recapitalized and maintained credit lines, reducing the intensity of the sudden stop and credit squeeze.

Fiscal consolidation intensity: over the first two years of the program, the cyclically adjusted primary balance was increased by 11% of GDP.
Political economy observations:
- Large initial budget cuts were implemented relatively easily; smaller subsequent steps proved more difficult (2011 budget example).
- The political argument for front loading is described as fairly strong.
- The political argument for focusing on spending cuts initially is also emphasized:
- Targeted spending cuts are typically more costly politically than general tax increases,
- It may be better to reserve tax increases for later, if and when adjustment fatigue sets in.

Many supportive conditions present in Latvia are not satisfied in Europe’s southern periphery.
Comparative constraints in the South:
- Adjustments required are smaller than Latvia’s but economies are less flexible and less open,
- Less obvious potential gains in productivity in tradables,
- Much higher public debt to start.
Conclusion: The lessons are not easily exportable; adjustment in the South will be difficult and painful.
Policy implication for the South: a social pact and faster joint adjustment of wages and prices than implied by market mechanisms remains a very strong recommendation.

Source: Olivier Blanchard, "Lessons from Latvia", June 11, 2012.