Lessons from Latvia's internal adjustment

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Presentation by Ilmārs Rimšēvičs, Governor of the Bank of Latvia at Country workshop: "EU Balance-of-Payments assistance for Latvia: Foundations of Success" organized by the European Commission, Directorate General for Economic and Financial Affairs, and the Bank of Latvia.
Brussels, March 1, 2012

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Lessons from Latvia's internal adjustment

  1. 1. Lessons from Latvia’s internal adjustment Ilmārs Rimšēvičs Governor of the Bank of Latvia March 1, 2012
  2. 2. Origins of the recent Crisis?The past growth was fuelled by massive capital inflows,building up excessive demand and a real estate bubble Bank of Government Commercial Labour FDI EU Funds Latvia budget Banks remittances 1 EUR = 0.702804 LVL
  3. 3. Labour market overheated significantly, driving wages above productivity and hurting competitiveness Wages and productivity, 2000=100 200 190 180 170 160 150 140 130 120 2004 2005 2006 2007 2008 Productivity Real wageSource: CSB, Bank of Latvia staff calculations
  4. 4. Excessive demand showed up in massive current account deficits Current account balance, % of GDP 0.0 -5.0 -6.7 -8.2 -10.0 -12.9 -12.6 -15.0 -20.0 -22.6 -22.4 -25.0 2002 2003 2004 2005 2006 2007Source: Bank of Latvia
  5. 5. GDP was pushed up by banks borrowing abroad andchannelling funds into economy to nurture massive lending boom, until the bubble collapsed Credit to residents, % y-o-y 70 +60.4 60 50 40 30 20 10 0 -8.2 -10 I 2011 I 2004 I 2005 I 2006 I 2007 I 2008 I 2009 I 2010 I 2012Source: Bank of Latvia
  6. 6. Latvia at the outset of the recent crisisMany suggested devaluation as a way out of the crisis. Why devaluation was not an appropriate solution?
  7. 7. Devaluation is not a solution for Latvia High import content in exports and domestic produc- tion, competitive gains reduced by surge in input costs No immediate improvement in the current account (Marshall-Lerner condition is not met) High share of FX liabilities: many corporates would face negative equity immediately Loss of credibility and likely run on banks Court system unable to cope with sharp increase in insolvency cases, inefficient insolvency procedure No motivation to improve efficiency and productivity
  8. 8. The internal adjustment was the only path to follow Time bought for structural reforms that smoothen adjustment Improvement of public sector efficiency Less corporate bankruptcies reduce costs for the economy More gradual adjustment motivates businesses for productive improvements Latvia’s economy is reasonably flexible to adjust Society understands the root causes of crisis and supports necessary austerity and reforms
  9. 9. Despite loud ex ante warnings of protracted recession risks under internal adjustment scenario, a strong “V” shaped recovery followed Real GDP growth, % 15 10 5 5.3 0 -5 -10 -15 -20 2006 2007 2008 2009 2010 2011FSource: CSB; F – Bank of Latvia forecast
  10. 10. Latvia has implemented sizable fiscal consolidation underpinned by structural reforms Breakdown of budget consolidation measures, % of GDPSource: Ministry of Finance; Bank of Latvia staff calculations
  11. 11. Indeed, Latvia and other Baltic countries have clearly benefited from getting through the internal adjustment at an early stage GDP growth in 2011, % y-o-y 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 Latvia Sweden* Ireland* Cyprus Spain France Slovenia* Poland* Greece* Italy* Hungary Portugal* Bulgaria* Austria Lithuania Slovakia Netherlands Malta* Finland Belgium* UK* Czech Rep.* Estonia Romania* Luxembourg* Germany Denmark*Source: Eurostat; * - EC Interim Forecast (February 2012) for those countries, whose GDP data is not yet available for the year as a whole
  12. 12. How Latvia managed to accomplish what initially was claimed being impossible?  Speed  Ownership  Commitment  Solidarity
  13. 13. 0 5 -5 10 15 20 EstoniaSource: Eurostat Lithuania Czech Republic Latvia Romania Slovakia Bulgaria Spain Hungary Sweden Germany Slovenia Austria Denmark Italy Portugal Poland BelgiumUnited Kingdom France Netherlands Cyprus Ireland Luxembourg Iceland Finland Greece Latvia ranges among the export leaders in Europe Exports already well above the pre-crisis peak level; Real growth in exports of goods and services, first three quarters of 2011, % y-o-y Malta
  14. 14. Recovery was largely underpinned by regained competitiveness: wage-productivity gap has been closed Real hourly wage and labour productivity per hour (seasonally adjusted), 2005 Q1 = 100 150 140 130 120 110 100 90 80 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 Labour productivity Real wageSource: CSB; Bank of Latvia staff calculations
  15. 15. Export market shares increase is among the strongest in the group of new EU member states Latvia’s merchandise export shares in world export, 2002=100 220 210 Bulgaria 200 Czech Republic 190 Estonia 180 170 Hungary 160 Latvia 150 Lithuania 140 130 Poland 120 Romania 110 Slovakia 100 Slovenia 90 2002 2003 2004 2005 2006 2007 2008 2009 2010 Q1 Q2 Q3 2011Source: WTO
  16. 16. External imbalances have been corrected quickly: current account remains close to balance Balance of Payments, % of GDP15.0 8.610.0 5.0 3.0 -0.5 -0.6 0.0 -5.0-10.0-15.0 -13.1-20.0-25.0 -22.6 -22.4 2006 2007 2008 2009 2010 2011F 2012F Goods and services Income Current transfers Current accountSource: Bank of Latvia; F – Bank of Latvia forecast
  17. 17. Latvia has regained investor confidence Net FDI inflows, mln LVL (ex banking and real estate, moving average)160.0 Net FDI inflows in 2011:140.0 5.8% of GDP120.0100.0 80.0 60.0 40.0 20.0 0.0-20.0-40.0 IV II IV II IV II IV II IV II IV II II IV II III III III III III III III III I 2005 I 2011 I 2004 I 2006 I 2007 I 2008 I 2009 I 2010 IV*Source: Bank of Latvia; * - preliminary data
  18. 18. In contrast to countries that responded to crisis by devaluing and imposing capital controls, Latvia has experienced a strong rebound in investment Gross fixed capital formation, % y-o-y 40 28.6 30 24.4 21.9 20 10 0 -10 -20 -30 -40 -50 IV IV II IV II II IV II II III III III III III I 2008 I 2007 I 2009 I 2010 I 2011Source: CSB
  19. 19. With sizeable fiscal adjustment budget balance is expected to reach sustainable levels General Government balance (ESA’95), % of GDP 0 -0.4 -1.0 0.0 -2.5 -2 -4.0 -4.2 -4 -8.3 -9.7 -6 -8 -10 -12 -14 -16 -18 -20 2007 2008 2009 2010 2011 2012F 2013F 2014F Consolidation effort Actual (targeted) balanceSource: Eurostat, BoL staff estimation
  20. 20. Public debt has stabilized at around 45% of GDP; well below initially expected peak of close to 100% of GDP General government gross debt (ESA95), % of GDP 60 50 40 30 20 10 0 2007 2008 2009 2010 2011F 2012FSource: Eurostat; F -Bank of Latvia forecast
  21. 21. Current forecast scenario implies that Latvia is expected to comply with the Maastricht inflation criteria since the beginning of 2013 Maastricht criteria estimate forecast and 12 month average inflation, % 5 4 3 2 1 0 Maastricht criteria* -1 -2 12 month average inflation -3 I 2010 IV VII X I 2011 IV VII X I 2012 IV VII X I 2013 IV VII XSource: CSB, EC autumn 2011 forecast; Bank of Latvia forecasts and staff calculations
  22. 22. The aim of introducing Euro in 2014 is well within reach General Government budget balance (ESA95), % of GDP 0.0 0.0 -1.0 -0.4 -1.0 -2.0 -3.0 -2.5 -4.0 -4.2 -4.0 -5.0 -6.0 EURO -7.0 -8.0 -9.0 -8.3 -10.0 Budget strategy Measure- -9.7 -11.0 ment -12.0 2007 2008 2009 2010 2011 2012F 2013F 2014FSource: Eurostat, BoL staff estimation
  23. 23. Many European countries still suffer from weak public finance discipline Budget balance, % of Public debt, % of GDP* GDP growth, % Inflation, % GDP* 2011 2012 2011 2012 2011 2012 2011 2012 Greece 162.8 198.3 -8.9 -7.0 -6.8 -4.4 3.1 -0.5 Italy 120.5 120.5 -4.0 -2.3 0.2 -1.3 2.9 2.9 Ireland 108.1 117.5 -10.3 -8.6 0.9 0.5 1.2 1.6 Portugal 101.6 111.0 -5.8 -4.5 -1.5 -3.3 3.6 3.3 Belgium 97.2 99.2 -3.6 -4.6 1.9 -0.1 3.5 2.7 Euro area 88.0 90.4 -4.1 -3.4 1.4 -0.3 2.7 2.1 France 85.4 89.2 -5.8 -5.3 1.7 0.4 2.3 2.2 EU 82.5 84.9 -4.7 -3.9 1.5 0.0 3.1 2.3 Germany 81.7 81.2 -1.3 -1.0 3.0 0.6 2.5 1.9 Austria 72.2 73.3 -3.4 -3.1 3.1 0.7 3.6 2.4 Spain 69.6 73.8 -6.6 -5.9 0.7 -1.0 3.1 1.3 Malta 69.6 70.8 -3.0 -3.5 2.1 1.0 2.4 2.1 Cyprus 64.9 68.4 -6.7 -4.9 0.5 -0.5 3.5 2.8 Netherlands 64.2 64.9 -4.3 -3.1 1.2 -0.9 2.5 2.0 Finland 49.1 51.8 -1.0 -0.7 2.7 0.8 3.3 3.0 Slovenia 45.5 50.1 -5.7 -5.3 0.3 -0.1 2.1 1.6 Slovakia 44.5 47.5 -5.8 -4.9 3.3 1.2 4.1 1.9 Luxembourg 19.5 20.2 -0.6 -1.1 1.1 0.7 3.7 2.7 Estonia 5.8 6.0 0.8 -1.8 7.5 1.2 5.1 3.1* - marked = non compliance with Maastricht criteriaSource: EC Autumn 2011 forecasts (public finance data), EC February 2012 forecasts (GDP and inflation)

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