Latvia: Milestones on the Road to Economic Recovery
By Oleg K. Temple, October 2009.
So let's pick up where we left off, thus far we have examined the factors that significantly eroded the competitiveness of Latvia such as unwarranted wage increases and low productivity. We have established that Latvian policy makers under the firm hand and watchful eyes of the IMF, the European Commission and other powers have opted for the high road of domestic discipline and restrained spending while uprooting and eradicating problems that have disharmonized the economy. By choosing to crack down on the problems of the economy and reinforce the foundations for sustained competitiveness, the programme aims to avoid the ephemeral success of floating the Latvian lat, while sweeping the real problems under the rug. Experts agree that for the first time, the young country's government seems to be doing what is actually needed, but is it too little too late? Is there a chance that the crisis will continue to escalate until it boils over and the government buckles to the devaluation sermons of the Scandinavian press?
Continued from Baltic Tiger: In the Eye of the Storm
Devaluation | Containment & Recovery | Euromorphosis | Baltic Tiger
DEVALUATION: Could Latvia Meet the Marshall-Lerner Condition?
The short answer is nope. This feat is not a feasible reality for Latvia at this time. The Marshall-Lerner Condition dictates that for devaluation of a currency to have a positive impact on the balance of trade, the sum of price elasticity of exports and imports (in absolute value) must be greater than 1. Through devaluation the price of exports drops, thereby boosting demand, making the country more competitive and simultaneously, the cost of imports escalates resulting in a diminished domestic demand for foreign goods. The price elasticity factor plays a crucial role in determining the net effect imparted on the balance of trade by currency devaluation.
If the price of exported goods is elastic, increased demand will result in increased quantity demand, thereby increasing the overall revenue. Parallel to this, if the prices of imported goods are elastic, the overall import expenditure will be reduced. Both these effects would serve to benefit the trade balance, the catch is: these are not immediate solutions and hence, practically inapplicable in developing countries, because as a rule, consumer behaviour patterns adjust sluggishly, with a lag and are inelastic in the short-term.
In heavily industrialized nations with a well-established production and export sector, such as Sweden or China floating the currency is a viable option as they have stalwart anchors to keep their economies from drifting aimlessly and inevitably, getting sucked down the abysmal whirlpool of recession. These countries are typically nearly self-reliant in terms of fuel and energy and can afford to wait for the trade winds to turn.
| For instance, originally, the Chinese Renminbi was pegged to the dollar, in 2005 China opted to give itself more elbow room on the export stage by carefully floating its currency and when sure foothold was established, the People's Bank of China widened the spectrum of values in 2007. |  |
The 2005 peg lift resulted in an immediate one-off RMB revaluation vs. the US dollar. In contrast, Latvia would risk rigorous reorganization and would stand to lose more than it would gain from devaluation of the currency at this stage in economic development. The obvious solution for Latvia is to cut government spending and wean the market off heavy reliance on imported goods. This can be achieved through strategic investment in sustainable tradable sectors and promotion of home-grown business locally and abroad.
Righting the Wrongs: Containment and Recovery
Of course, comparing Latvia or Lithuania to Sweden or China is like comparing apples with bananas — fledgling economies with under-developed production facilities, require nearly immediate results from positive actions to contain the crisis and avoid continued collateral damage. Once the immediate first aid measures to staunch the gushing wounds have been successfully implemented, the policy-makers may then turn their attention to mid-range and long-term plans for sustainability, but first things must be tackled first.
So IMF, European Commission, World Bank, EBRD and the other donors and coordinators came up with a battle plan for Latvia with clear-cut targets for the structural adjustment programme:
- The short-term goals are: to regain control and stabilize the financial sector, regain confidence of depositors, and avoid the chaos that would ensue if the exchange currency peg were relinquished.
- The mid-range program focuses on promoting economic adjustment and reinforcing the pegged value.
The structural adjustment programme includes:
- Significantly reducing the domestic spending and future financing needs, thereby gradually, replenishing confidence in the system as a whole. In a recent study the World Bank recommended that the number of hospital beds should be reduced by 50% to lower expenditure on idle facilities. EBRD's 2008 Strategy for Latvia report brings the message home: "Latvia's public healthcare system is overburdened and severely under-financed: healthcare expenditure of around four per cent of GDP is only half of the western European average... there has also been a significant per capita decline in the number of medical personnel, many of whom have emigrated to Western Europe."
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Furthermore, the Latvian government could certainly use a LEANer fiscal outlook as the number of pork bellies scurrying around the governmental halls far outweighs the needs of the people. Mother Latvia can no longer support so many suckling civil "servants", so it is no surprise that pen-pushers and stamp-wielders can now be heard "squealing from the feeling" as they are herded off home in their hundreds to await better days and the next explosion in their population. In his interview with Dagens Industri, Mr. Ljungdahl also said that relative to the population, Latvia has 30% more public employees than Estonia and 100% more than Finland. Clearly, there is room for improvement here; |
- To enter the 3rd stage of EMU (Economic Monetary Union of Europe) and adopt the Euro as primary currency by 2012 by meeting the Maastricht deficit criteria (or the Euro Convergence criteria). Estonia is already Euro-ready. I wager that the Latvian economists and Europe as a whole will learn much from Estonia's attempt at the Euro-shift in January 2011;
- Structural correction policies to accelerate productivity growth and succour the conversion from production of non-tradable commodities (locally consumed goods and services) to that of tradables (production driven by demand in foreign markets).
- Stringent income policies to curb inflation and rekindle competitiveness;
2012: The "Euromorphosis" of Latvia?
This dream can only be accomplished by meeting the Maastricht requirement, forged to protect the macroeconomy of the Eurozone and ensure price stability despite the acceptance of new member states. The Maastricht requirement comprises four main criteria based on Article 121(1) of the European Community Treaty as follows:
1. Inflation rate: must be less than 1.5 percentage points above the average of the three best-performing (lowest inflation) member states of the EU.
2. Government finance:
a) Annual government deficit: The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year.
There are, however, positive forecasts for 2010, for instance, The Baltic Times recently heralded that Lithuania may be poised to resume economic growth already next year. A note-worthy highlight of this interview was the following comment by Governor Reinoldijus Sarkinas of the Central Bank: "The Baltic region is three separate countries with different situations, and one shouldn't put an 'equals' mark..." True, the situation of each Baltic country is quite unique, however, due to the fact that their capitalist economic era began at more or less the same time and in similar circumstances, they do, collectively make a fascinating study.
b) Government debt: The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year.
3. Exchange rate: Applicant countries should have joined the exchange-rate mechanism (ERM II) under the European Monetary System (EMS) for two consecutive years and should not have devaluated its currency during the period. Latvia met this criterion in May 2005, whereas both Lithuania and Estonia did so way back in June 2004.
4. Long-term interest rates: The nominal long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states.
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Malta is one of the latest countries to have successfully adopted the Euro as its currency on January 1, 2008 as the country had entered ERM II on May 4, 2005. Among the Baltic countries, Estonia is the only one to have met the four Euro Convergence criteria so switching to Euros is a reality for the country. Estonian Euros have been designed since 2004, now the country can confidently begin to mint the currency in preparation for the switch between 2011 and 2013. Latvia and Lithuania still exhibit erratic, long-term interest rates of 12.6% and 14.5% respectively, overshooting the requirement by about 200%. |
Indeed, Estonia has also excelled at keeping down its gross govt. debt to GDP ratio — recorded at just 3.4% of GDP. In comparison, Latvia with 19.5% and Lithuania with 15.6% may seem to be in dire straits, but one must put things into proper perspective before passing judgement. Firstly, these figures are much lower than the cut off mark of 60% and secondly, in contrast, countries like Sweden are still unperturbed with debt to GDP at 35.5% and Norway's smiling despite a national debt of 53.5% of GDP. Yes, I know, comparing bananas and apples again. Norway's 1972 and 1994 public referendums opted to keep the country outside of the EU; its unemployment rate in June this year was recorded as low as 3% and the country has the world's 6th largest merchant fleet... Chuck Butler* adds: "Norway, with their North Sea Oil, has a very healthy balance sheet. In fact, it's so healthy that policymakers are creating one of the most enviable pension plans on earth. They actually have enough money in this mega-pension fund to guarantee every citizen receives a pension – including the next generation of Norwegians who aren't even born yet!" So besides being HSBC's pick of the litter currency-wise, Norway boasts a superlative social care programme.
Sweden is an export trade and banking superpower in Europe, ranked 4th on The Global Competitiveness Report prepared by the World Economic Forum for 2009 - 2010, with Switzerland, USA and Singapore reigning over places 1 through 3 respectively. Incidentally, this report gauged Latvia as number 68 of 133, with Lithuania on place 53 and Estonia, the Baltic fore-runner at number 35. Considering that both Latvia and Hungary are in the same stage (transition from 2nd to 3rd) of economic development, it is mildly surprising that Hungary was rated 10 rungs above Latvia on The Global Competitiveness Index even though the country has not fulfilled a single one of the Euro Convergence criteria.
It shouldn't surprise anyone that Estonia is the tidiest of the Baltic countries economy-wise. The country has repeatedly proven to have a knack for producing superb economists and finance-savvy politicians. Estonia has a long-standing cooperation with the Organization for Economic Co-operation and Development since the late '90s. More recently OECD opened membership talks with Estonia on 16 May 2007, an event that adds to the country's integrity and stands as clear proof of Estonia's resolve and commitment to economic stability and growth. Estonia participated in the OECD's Baltic Regional Programme, which from 1998 to 2004 was the OECD's main bastion for policy control and co-operation with the three Baltic states. The OECD's profile of Estonia confirms the country's tendency towards steady improvement and social welfare.
The Baltic Tiger Charges Again
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After all the scare-mongering done by the media and the miles of negative press released about Latvia, it was a genuine pleasure and a relief to see the visual of the competitiveness report 2007-2009 (left), with the dark green colours marking the best and bright red marking the countries with the weakest economies. Evidently, Latvia is not as lost as the press would have us believe. The WEF Report also cited "The most problematic factors for doing business" in Latvia as a) Inefficient government bureaucracy (15.5%); b) Access to financing (15.4%); c) Tax regulations (13.5%); d) Tax rates (10.3%); e) Policy instability (9.2%). |
It is important to note, however, that various reports produce varying results and I urge the reader to weigh the evidence presented in a sober, non-biased manner - otherwise the facts can be construed to mean anything. Consider this: The World Bank's DOING BUSINESS Report 2010 places Latvia on the 27th place out of 183 countries examined in relation to the ease of doing business, based on 10 distinct criteria. That is 3 places higher than last year and the report shows that doing business in Latvia is EASIER than in Spain, France, Netherlands, Poland, Greece, Italy, Hungary (which dropped from number 41 in 2009 to number 47 next year) and 149 other countries. Well done, Latvia! Incidentally, since last year's report Lithuania dropped one rung and Estonia dropped by two pegs to places 26 and 24 respectively.
Another interesting deduction was put forth by Mr. Ljungdahl, in his article for the American Chamber of Commerce' magazine "American Investor". In his article Mr. Ljungdahl points out that the main enemies of progress in Latvia are: lack of unity amongst the politicians; the lack of resolve to adhere to undertakings and goals agreed with international donors; and the progress-impeding drag created by the critics of the chosen solution and advocates of devaluation. On the flip-side, one thing that Latvia has going for it is the flexible labour market – unlike many of the developed countries where the employers are muscled by powerful labour unions. As a result, wage packets may be cut without too much hassle, as workers make heavy concessions to keep their jobs. Entrepreneurs may then pass these savings on to the consumer, reducing prices of goods and services, thereby boosting value and in turn nurturing demand.
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"I think that one fundamental problem is lack of historic knowledge. Most people are unaware of or disregard the tremendous development that has taken place since independence and they concentrate on the problems without seeing their virtues, like the low public debt. For sure there has also been an almost hysteric campaign in especially the Swedish press, possibly originated in the Swedish banks' involvement in the Latvian economy. In that campaign everything has been presented in negative terms. Happily, those actions have now abated." GUNNAR LJUNGDAHL, CEO of EPSI Baltic |
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On the world stage, Latvia's inadequacies smell like summer roses when you consider the recent report on British National Debt by NewsScotsman: as UK unemployment soared and tax revenues crumbled the nation's debt was clocked at £800.8bn last month. This gargantuan figure accounts for 56.8 per cent of gross domestic product (GDP), its highest level since records began. Nevertheless, UK ranks number 13 on the Global Competitiveness Index. LEFT: A tell-tale image from the Q2 2009 UK Output, Income and Expenditure statistical bulletin, by the UK National Statistics Bureau. |
| Still not convinced that Latvia has a good fighting chance? Checkout the latest stats from Wikipedia's "Public debt percent GDP world map 2008-2009" (right) – as you can see Latvia and her Baltic sisters have a pristine reputation whereas the rest of Europe looks somewhat more "bruised" by debt. |  |
If present course and resolve are maintained, Latvia will surely break free from the grip of the crisis and resume economic growth a year from now. I believe that the recession had a positive effect on the government and people as a whole. Such a close brush with destiny hammered the message home that policy makers must cease vain, myopic planning, desist from plundering for personal gain and think of what is necessary to keep the country going and growing. When Latvia recovers from this arduous ordeal, the economy will be stronger and built to last with wisdom and foresight, upon stalwart foundations. When the sweet ambrosia of success mingles with the acrid stench of uncertainty and fear (inspired by the looming recession, like it did in 2006 and 2007), it loses its appeal nonetheless. Thankfully, the people have now seen the light. There is no doubt that post-recession Latvia will be stronger, wiser, more confident, successful and stable.
* Chuck Butler is a Currency Expert and Editor of The Currency Capitalist and the free daily FX University Daily
Sources: Wikipedia, Ashurst Weekly Economic Update, Latvian Institute, Eurostat, The World Economic Forum; UK National Statistics; The World Bank; Organization for Economic Co-operation and Development
© Oleg K. Temple, CornerstonesWorld.com, 2009.
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