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Swedbank Analysis: Competitiveness adjustment in Latvia


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Swedbank Analysis: Competitiveness adjustment in Latvia

  1. 1. Swedbank Analysis March 23, 2010 Economic Research Department. Swedbank AB (publ). Lija Strašuna +371 6744 5875, Mārtiņš Kazāks +371 6744 5859, Legally responsible publisher: Cecilia Hermansson, Group Chief Economist, +46 8 5859 1588 Competitiveness adjustment in Latvia – no pain, no gain? • Deflation in full swing, competiveness gradually improving • Costs of deflation becoming more evident • Less painful way to improve competitiveness: target output growth and speed up structural reforms The double-digit economic growth in 2005-2007 in Latvia was clearly un- sustainable. A very fast and excessive leveraging of the private sector – credit stock more than doubled in three years, reaching levels vis-à-vis GDP comparable to those in advanced economies – resulted in a real estate boom- bust scenario. This process was driven by expansive fiscal policy, inadequate tax policy, excessive optimism on future incomes, globally low interest rates, sizable capital inflows, and banks’ competition for market shares. Excessive credit growth and optimism resulted in an unsustainable domestic demand growth, mainly in private consumption. The current account deficit expanded to above 20% of GDP in 2006 and 2007. A swiftly widening positive output gap resulted in excessive wage growth and double-digit inflation. The real estate bubble burst in mid-2007, marking the start of a comprehensive slowdown in the economy. Structural imbalances resulted in real estate boom-bust scenario The recession started in 2008 with domestic demand contraction. It was ex- acerbated by the global downturn in the second half of the year, which also caused exports to fall. The current account improved swiftly and was in sur- plus already in 2009. However, the previous procyclical fiscal policy and thus lack of savings, sharply fallen revenues due to the downturn, and need to bail out the largest domestically owned bank widened the government budget Need to improve external competitiveness to sup- port export-driven growth
  2. 2. deficit and made Latvia to apply for a bailout package in late 2008.1 Overlev- eraged domestic demand sectors cannot drive the economy out of the reces- sion. Consequently, to make the economy more balanced and ensure export- driven economic growth, external competitiveness must be improved. In 2005-2007, it worsened substantially due to an excess of wage growth over productivity growth, while in late 2008 and early 2009 depreciations of cur- rencies in some of the main Latvian trading partner countries2 exacerbated the situation. A country may improve its external competitiveness through (i) cost adjust- ment relative to its trading partners and/ or (ii) a “more clever” production. The first option may be achieved through devaluation of the currency or a local cost reduction (in an environment of low global inflation, usually imply- ing deflation). The second option demands structural adjustment in the economy – improvements in the institutional framework and productivity gains. To ensure that improvements in competitiveness are long-lasting, these two options should be combined. As the costs of devaluation in the Latvian case are forecast to exceed their benefits (see discussion and estimates of the Bank of Latvia for details3), the Latvian authorities are strongly committed to keeping the current exchange rate peg.4 The scenario that the Latvian government has thus chosen to fol- low is cost reduction, which is more of a short-term measure, combined with productivity-enhancing structural reforms,5 which usually have a medium- to long-term effect. In this paper we refer to this scenario as the “internal devaluation.” Competitiveness to be improved through cost reduction and structural adjustment To gauge the success of the internal devaluation and, thus, competitiveness gains, the indicator that is usually looked at is the real effective exchange rate (REER). In 2006-2008, the consumer-price-deflated REER of the lats ap- preciated by 22-25%,6 reflecting worsening competitiveness7. However, when judging the progress of the scenario, this measure should not be con- sidered as the sole relevant benchmark, as it does not always reflect the true competitiveness of a country’s exporters. In addition, the equilibrium level of the REER is likely to change due to structural adjustment in the economy (e.g. due to the Balassa-Samuelson hypothesis) and, thus, it is not always necessary to fully bounce back previous REER appreciation to regain com- petitiveness. REER should not be the sole benchmark used to judge success of internal devaluation This paper thus: (i) looks at the current progress in carrying out the internal devaluation, paying particular attention to labour market developments; (ii) 1 The high level of short-term external debt exposed Latvia to the risk of a sudden stop of capital inflows (see, e.g., IMF, 2009). Due to the global liquidity squeeze in late 2008, Latvia had no other choice but to turn for help to the IMF and the EC. The fiscal adjustment is well under way, but still a substantial fiscal consolidation is necessary to put public finances on a sustainable footing (see Kazāks, Strašuna, and Stikuts, 2009, for more details). 2 E.g. Sweden, Russia, the UK, and Poland (comprising about 24% of total goods exports). From Oc- tober 2008 to March 2009, the nominal effective exchange rate of the lats appreciated by 6.5%. 3 <> 4 Since 1 January 2005 the lats is pegged to the euro at the central parity rate of 0.702804 lats for one euro, with an allowed fluctuation band of +/- 1%. 5 This is also the underlying approach of the IMF- and EC-supported bailout package for Latvia (see IMF, 2009). 6 Depending on how many trading partners are to be considered in calculations. The Bank of Latvia calculates the REER with 13 main trading partners (in total comprising about 80% of total goods trade turnover), which appreciated by 25% over this period. Eurostat data, which take into account 41 trading partners, show a smaller appreciation of 22%. According to the Bank of Latvia, until its peak in March 2009, the REER had already appreciated by 30%. 7 Our previous research showed that until 2005 the lats was about adequately valued (Kazāks, Kūle, and Strašuna, 2006). IMF (2006) concluded that the REER was slightly undervalued in 2004-2005. Given that during 2006 REER remained by and large stable, 2006 is taken as a reference level. 2 Swedbank Analysis • March 23, 2010
  3. 3. outlines the costs of the internal devaluation scenario; (iii) suggests policy solutions to make further adjustment less painful for society. 1. THEORETICAL FRAMEWORK 1.1 How the internal devaluation scenario works To ensure long-lasting improvement in competitiveness, structural adjustment is necessary As stated above, competitiveness is improved through cost reduction (i.e., deflation) and productivity-enhancing structural reforms (see Figure 1). Long-lasting improvement in competitiveness is ensured by carrying out structural reforms in every part of the model – cost adjustment, productivity, and institutional framework improvements. By the institutional framework we mean taxes, the business and legal environment, etc., which affect both prices and productivity. Figure 1. How to improve competitiveness Deflation Productivity Product markets (e.g., falling com- modity prices) Decreasing employment Increasing output Production process improvements Institutional framework Factor markets (e.g., cut labour costs) Competitiveness Deflation is defined as a sustained decline in aggregate prices,8 caused by either a fall in aggregate demand or an increase in aggregate supply. Nor- mally, the final price for a product or service comprises a company’s costs – including labour costs, input material costs, administrative expenses, etc. – its profit margin, and taxes. To improve competitiveness, a reduction in costs is required and perhaps a profit margin squeeze. For a small and open economy, it is crucial to distinguish between local and foreign input and fi- nal prices A price fall in product markets (i.e., commodity prices) is one side of the defla- tionary process. Cheaper materials cause producer prices to decline and re- sult in consumer price deflation. For a small and open economy, such as Lat- via, it is also vital to distinguish between local and foreign input and final prices. First, they influence market structure, as companies operating in local and external markets might face different environments. Second, these prices consequently affect the contribution of consumption and exports to GDP growth. Labour cost cuts must not be the overriding strategy as it strengthens social problems Deflation in factor markets is mainly reflected in labour market tendencies.9 The adjustment may come through either wage cuts or job destruction (i.e., a fall in employment). Wages might be cut more easily when unemployment is already high due to the diminishing bargaining power of employees. How- ever, wage reduction and job destruction should not be the overriding strat- egy, as they also trigger a negative spiral by undermining domestic demand. 8 See e.g. Burdekin and Siklos (2002), Buiter (2003), Decressin and Laxton (2009), IMF (2003), and Bernanke (2002). In most cases, asset price changes are not considered in the deflation definition. 9 Capital costs are mostly dependent on euro interest rates, which Latvia cannot influence (although wider risk margins surely add to the costs). Swedbank Analysis • March 23, 2010 3
  4. 4. Also, while lower employment improves productivity, it does not ensure con- tinuation of productivity growth afterwards.10 In addition, job destruction might result in long-term structural unemployment, increasing inequality, and rising social problems. An alternative opportunity to reduce costs that has smaller negative spill- overs to labour market and domestic demand is to structurally improve the production process, including logistics, process optimization, customer ser- vice, etc. Improved production process would not only diminish costs, but may also increase production capacity. Increasing output (i.e., production volumes) rather than simply aiming for lower labour cost should be the tar- get. One approach is to find new markets and/or products to be able to raise sales. Productivity gains in the public sector (e.g., efficient health care, edu- cation, and public administration) are as important as productivity growth in the private sector, albeit harder to measure. Improvements to the institu- tional framework might also improve competitiveness by diminishing costs to businesses, e.g., by lifting administrative barriers or rearranging the tax burden. 1.2 Some deflation measurement caveats Consumer price changes are not the best bench- mark for measuring competitiveness gains Usually consumer price index (CPI) changes are used as an indicator of defla- tion. IMF (2003), however, mentions several disadvantages to using this indi- cator. First, the CPI is Laspeyres base weighted and, hence, does not allow for substitution possibilities. Second, quality improvements of the goods and services are not reflected adequately in the CPI. Nevertheless, the CPI is the most common measure of deflation as it is relatively easy to calculate, com- parable across countries, and not revised afterwards.11 It should be empha- sized that the CPI illustrates only consumer prices, which are not always a good proxy for exporters, and does not differentiate between tradable and nontradable goods, as well as local and foreign input prices. A small and open country is a price taker and, by and large, cannot influence global prices. In the case of Latvia, about one-third of its consumer basket is composed of im- ported products.12 This means that CPI may disguise the true depth of defla- tionary pressures and its negative side effects (see section 2.5). For instance, rise in imports prices may partly/ fully/ more than fully outweigh deflation in prices of domestic origin. 2. TAKING STOCK OF THE ADJUSTMENT SO FAR 2.1 Competitiveness has improved Progress certainly has been made in following the internal devaluation sce- nario. Competitiveness has started to improve – by the end of last year, the CPI was down by 4.5% from its peak in March 2009, and the producer price index (PPI) by 10% from its peak in the autumn of 2008. From the peak in March 2009, about one-fourth of the CPI-deflated REER appreciation since 2006 has already been recovered, i.e., it is down by 6.8% from its peak. In the 4th quarter of 2009, unit labour costs (ULC) were already declining by 21% in annual terms. The REER deflated by ULC has already depreciated by 14% Competitiveness has improved… 10 Average labour productivity is usually measured as GDP per employed or per working hour. If employment falls more than GDP, that immediately raises productivity. However, this does not imply permanent productivity growth and, thus, productivity convergence with the EU. 11 The GDP deflator is also often used, as it is a broader measure of overall price development. Yet, the GDP deflator is commonly revised, which makes it difficult to use. 12 The authors’ estimate. This is a direct influence; the indirect one is even larger (e.g., gas and heat- ing prices going up due to global oil price increases). 4 Swedbank Analysis • March 23, 2010
  5. 5. from its peak in the 3rd quarter of 2008, an amount equivalent to about 40% of the appreciation since 2006. The Bank of Latvia estimates of export mar- ket shares finds further support to improving competitiveness – market shares of Latvian exporters in their key export markets have either remained stable or improved. Figure 2. Competitiveness indicators, 2005=100 100 110 120 130 140 Jan.06 Jan.07 Jan.08 Jan.09 Jan.10 CPI deflated REER PPI deflated REER Source: Bank of Latvia Figure 3. Competitiveness indicators 100 120 140 160 1Q 06 1Q 07 1Q 08 1Q 09 -30 0 30 60 REER deflated by ULC, 2005=100 (ls) ULC, % yoy (rs) Source: Bank of Latvia Despite the adjustment made so far, further improvements are necessary, according to both the REER and ULC measures. This can also be seen by comparing Latvian developments with those of its main trading partners. Looking at CPI-based REER developments, the competitiveness gap between Latvia and the euro area still exists (even if the underlying equilibrium rate has increased due to structural improvements, the improvement clearly has not been that strong to close the gap).13 …but adjustment is not over yet Figure 4. REER based on CPI (2005=100) 70 80 90 100 110 120 130 140 Jan.06 Jan.07 Jan.08 Jan.09 Jan.10 EE LV LT SE RUS UK EA Source: BIS, Reuters Figure 5. Real unit labour costs (4Q average), 2005=100 90 95 100 105 110 115 120 4Q 05 4Q 06 4Q 07 4Q 08 EE LV LT SE UK EA Source: Eurostat Another indicator that may better show the competitiveness of a country’s exporters is real unit labour costs (RULC).14 This suggests a similar conclu- sion – there is still room for improvement, although a lot has been done al- ready. 13 One should be careful in comparing levels as in the figure it is presumed that in 2005 the competi- tiveness level was the same for everybody, which is obviously not true. However, assuming the Lat- vian exchange rate was adequately valued in 2006 and the euro area REER has been stable since then, we see that there is still room for improvement. 14 These are calculated as compensation per employee in current prices divided by GDP in current prices per total employment (Eurostat definition). The RULC thus shows the relationship between how much each employee is paid and the value each employee produces by his/her work (while the ULC show how much each employee costs to produce one unit of production). Real unit labour costs performance relative to 35 industrial counties (provided by DG ECFIN) shows a very similar picture as in Figure 5. Swedbank Analysis • March 23, 2010 5
  6. 6. 2.2 Producer price deflation deeper than that of consumers In 2009, deflation in product markets was supported by a fall in both foreign and local input prices. In the beginning of the year, a major influence came from a price decline in global commodity prices (including oil), while at the end of the year the deflationary pressure of locally produced goods and ser- vices became more pronounced. The CPI fall was smaller than that of the PPI, reflecting substantial inertia in the price formation process, as well as insti- tutional factors. For instance, excluding the influence of tax changes,15 by the end of 2009 the CPI had already fallen by 7.4% from its peak in October 2008, while the fall in the full or standard CPI was only 2%. Consumer price deflation is slowed by institutional factors Figure 6. Annual price changes, % -15 -10 -5 0 5 10 15 20 25 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 CPI PPI, exported (rs) PPI, locally sold (rs) Source: CSBL Figure 7. Price level, 2005=100 100 110 120 130 140 150 160 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 PPI, manufacturing CPI (constant tax rates) CPI, goods CPI, services Source: CSBL Increasingly different environments for exporting and domestic demand sectors With the global economic recovery and, thus, rising prices of imported re- sources, the environments in which exporting businesses and those oriented towards the domestic demand operate are becoming increasingly different. While exporting sectors can now sell their products for higher prices in the world markets, domestically oriented sectors still face weak demand, which pushes their final product prices down. The most difficult financial situation is for those that purchase most of their inputs abroad and sell their output in the local market – their profitability16 and thus ability to service their exist- ing debt is squeezed further. Such price developments raise attractiveness of export industries and direct resources away from domestic demand indus- tries. So far, rising exports cannot compensate for weak domestic demand, and GDP was still contracting in the 4th quarter of 2009. However, the ex- port share in industry turnover is slowly growing (from 51% in 2008 to 57% in late 2009) and is expected to rise further. During the next five years, we forecast the export share in GDP to rise to 55% (from 45% in 2009). 15 CSBL estimate. There was a VAT rise in January 2009 (from 18% to 21%), as well as several ex- cise tax changes. The VAT increase does not worsen the competitiveness of exporters, as they do not pay VAT on their sales. 16 Official statistics do not provide good quality business profitability data. But in view of rapidly falling GDP, turnover and high level of credit overdues, profit margins must have shrunk greatly and the pressure to reduce them (if any are left) still remains, particularly in domestic demand sector. 6 Swedbank Analysis • March 23, 2010
  7. 7. Figure 8. Seasonally adjusted GDP, qoq growth -15 -10 -5 0 5 10 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 GDP Domestic demand Exports Source: CSBL Figure 9. Confidence indicators -60 -45 -30 -15 0 15 30 Jan.06 Jan.07 Jan.08 Jan.09 Jan.10 Consumer Manufacturing Retail Services Source: DG ECFIN 2.3 Labour market adjustment biased towards job destruction Larger wage cuts in the public sector Adjustment in the labour costs has been much more remarkable than in product prices. In the 4th quarter of 2009, labour costs17 were already 34.5% lower than their peak a year ago. The major bulk of this decline came through job destruction (i.e. employment cuts or raising part-time employment), with only about one-third of the total fall in the wage bill occurring through wage cuts.18 We are of the opinion that a more balanced split between wage cuts and job destruction would be more efficient. In addition, most of the wage reduction is attributable to the public sector,19 while wage cuts in the pri- vate sector have been fairly minor on average (-4.9% since the 4th quarter of 2008).20 Figure 10. Wage bill growth, % -40 -20 0 20 40 60 1Q 06 1Q 07 1Q 08 1Q 09 Nominal gross wage, yoy Wage bill, yoy Source: CSBL Figure 11. Jobseekers and employment, % -40 -20 0 20 40 60 1Q 06 1Q 07 1Q 08 1Q 09 -20 -10 0 10 20 30 Job seekers rate (rs) Wage bill, yoy (ls) Source: CSBL 17 These costs include the wage bill (basic salary, regular and irregular premiums and bonuses, vaca- tion payments, state mandatory social insurance contributions paid by the employees, and personal tax) and other labour costs ( state mandatory and voluntary social security contributions paid by the employer, employer’s allowances, awards, gifts, sick list payments, severance payments, and busi- ness risk state duty). 18 In Lithuania about 45% of the wage bill adjustment came through wage cuts; in Estonia, about 65%. Note that the wage is calculated per full-time equivalent, i.e. employee income declines even if hourly wage is stable, but the number of worked hours diminishes. 19 The larger wage cuts in the public sector were largely attributed to an unwillingness to reduce the number of carried functions/ services (which would reduce the number of employees). It was also because drafting reforms takes time and in a situation of a liquidity squeeze wage cut is a quick fix; yet, it might dent employee motivation. 20 Swedbank estimates point to a larger decrease in the private sector wages than is shown in the offi- cial statistics. In addition, wage developments differ across sectors (e.g. IT industry has reported ris- ing wages), see also Fontes (2010). Swedbank Analysis • March 23, 2010 7
  8. 8. Table 1. Changes in total wage bill as of 4Q 2009, yoy (%) Wage bill, of which: gross wage FTE* Total -34.7 -12.0 -26.0 Public sector -34.2 -23.7 n/a Private sector -35.1 -4.9 n/a * FTE - full time equivalent employment Source: CSBL Evidence suggests that wages are sticky downwards.21 However, with un- employment growing, the bargaining power of employees diminishes, and trade union influence is weak in Latvia.22 The job-seekers’ rate had ap- proached 20% by the end of 2009, but the link between unemployment and wages is still seems to be weak (see Figure 2). According to the salary survey done by the consultancy agency Fontes, businesses still do not consider high unemployment as a crucial reason to cut wages23; in case further adjustment is needed, reducing the number of employees is still the first choice. In addi- tion, there is strong institutional inertia – the majority of businesses revise remuneration packages only once a year.24 Private sector labour cost improvement due to a dramatic fall in employment Figure 12. Competiveness improvements via labour market, as of 4Q 2009 Labour cost cuts Wage cuts Reduction in number of employees and working hours Unemployment growth -26% yoy Job-seekers rate at 19.7%, up from 9.9% a year ago -12% yoy -34.5% yoy Job destruction might be a better solution at the early stage of correction – there were clearly excessive employment levels in many domestic demand industries during the boom. By now employment in Latvia is already back to its 2002 level, meaning that significantly more jobs have been destroyed during the recession than were created during the boom. While in short term and on a company level this could well be the most efficient solution, in longer term and on macro level it creates a number problems – this situation leads to long-term unemployment, increasing inequality and social pressure, and destroys human capital (people gradually lose their skills and are not able Very deep job destruction creates social problems in the longer term 21 The IMF mission pinpointed this as a potential problem already in the 2009 Stand-By Arrangement and recommended to coordinate wage cuts in the private sector together with the social partners (IMF, 2009). 22 Mostly present in the public sector. 23 Only about 10% of respondents mentioned unemployment growth as a stand alone reason for revis- ing wages. However, it should be taken into account that Fontes (2010) sample is biased towards large and medium sized foreign-owned companies. Those businesses typically have deeper pockets and are able to cut wages less aggressively than smaller locally-owned companies. 24 Fontes (2010) survey data show that 74% of businesses revise remuneration packages once a year, majority of them do this at the beginning of the year. In early 2009 unemployment rate was not that high yet to cut wages sharply. One likely reason for relatively small wage cuts thereafter could have been due to perhaps unwillingness of businesses to be the first to cut wages not knowing competitors’ plans – they would risk to lose their best employees. One does not face such a first mover problem when employment is cut. Given that further competitiveness gains are needed and unemployment is already very high, we are likely to see relatively more pronounced wage cuts in 2010. 8 Swedbank Analysis • March 23, 2010
  9. 9. to find jobs). It also strengthens emigration,25 which exacerbates the prob- lem of the aging population in Latvia (as usually those emigrating are of working age) and entails additional costs to the government budget.26 We are of the opinion that a more balanced mix of wage and employment cut would have been more efficient. 2.4 Productivity gains insufficient so far The wage developments are of particular concern, taking into account the notable excess of wage growth over productivity growth during 2006-2008. So far, productivity gains are observable only if they are measured using GDP per employed as a full-time equivalent (FTE).27 Due to substantial cuts in working hours, a number of FTEs declined more than employment, thus also improving productivity. However, these early gains have been relatively “easy pickings” – output volume should be constantly raised to ensure persis- tent productivity growth and, thus, convergence with the EU. Productivity gains have been “easy pickings” so far; output should be raised to ensure long- term growth Figure 13. FTE productivity and real wage, % -30 -20 -10 0 10 20 30 1Q 06 1Q 07 1Q 08 1Q 09 Excess wage over FTE productivity growth FTE productivity, % yoy Source: CSBL Figure 14. GDP and labour productivity, % of EU15* 30 35 40 45 50 55 1999 2001 2003 2005 2007 GDP per capita (purchasing power parity) Labour productivity per person employed * 2005 - break in series Source: Eurostat Huge potential for productivity growth Overall, despite the already large adjustment in the labour market, the proc- ess is not yet over. Real unit labour cost developments (see above) suggest that the adjustment should continue. In order to reduce the pressure on the labour market and arising negative side effects (see sections 2.3 and 2.5), further competitiveness improvement needs to come via productivity en- hancing structural reforms driven output growth. Average labour productiv- ity in Latvia was about 50% of the EU15 average in 2008, implying huge po- tential for improvement. One must mention that deflation without produc- tivity enhancing structural reforms is very unlikely to create sufficient im- provement in competitiveness. Although labour market may still tolerate some further wage and employment cuts to reduce costs, free labour move- ment within the EU provides an opportunity to emigrate significantly re- duces sustainability and depth of such cuts28. 2.5 Pain of deflation becomes more pronounced Research shows that even mild but continuous deflation may increase eco- nomic uncertainties, distort resource allocation, and entail distributional con- sequences (see, e.g., IMF, 2003; Baig, 2003). While deflation is needed in Lat- Deflation has negative side effects 25 Wage cuts have similar consequences, though. 26 High unemployment is a waste of resources, as unemployed persons do not generate any income. Consequently, this is associated with a loss of tax revenues. It also creates social pressure and in- crease incentives for tax evasion, as other groups of society are forced to bear the costs of unem- ployment. 27 Data on hourly productivity is not used due to its poor quality. 28 In 2008 average labour cost in Latvia amounted to about a quarter of the EU27 average, which may not only illustrate low labour cost but also motivation to emigrate. Average price level has converged to about 70% of the EU27 average. Swedbank Analysis • March 23, 2010 9
  10. 10. via to improve competitiveness, it is also a cause for concern. There are two main problems: (i) negative domestic demand spiral, and (ii) more difficult de- leveraging exacerbated by rising real interest rates. 2.5.1 Domestic demand to remain weak In two years, private consumption has already fallen by 34% from its peak in the 3rd quarter of 2007. While in the beginning mostly precautionary cuts were made, driven by weakening confidence, during 2009 labour market de- velopments became more and more influential. While households have been benefiting from lower consumer prices (mostly in the 2nd half of 2009, due to tax rises in the beginning of the year), they have at the same time been ex- periencing pressure on their incomes. Soaring unemployment also increases income inequality. Consumption patterns have changed, as can be seen, e.g., in consumer basket changes – in 2009 households spent more on food and housing (i.e., first-necessity items), thereby adjusting to the worsened finan- cial situation. Anecdotal evidence suggests also a shift to cheaper products and products with discounts. Figure 15. Household consumption and income in current prices, yoy (%) -50 -25 0 25 50 1Q 06 1Q 07 1Q 08 1Q 09 Private consumption Wage bill Pension income Source: CSBL, State Social Insurance Agency Figure 16. Household consumption and income in current prices, millions of lats 500 1000 1500 2000 2500 3000 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 Consumption Resources to spend* Wages and salaries Source: CSBL, Bank of Latvia * Wages and salaries + pension income + change in deposits - change in credits Confidence started to recover in 2009 with households and businesses gradually adapting to the crisis. However, confidence is still at low levels and has not yet translated into real economic activity. We forecast that private spending will remain weak in 2010 as labour market usually follow economic developments with a lag and household incomes will thus continue to decline at least in the first half of the year. A slow and thus consumption is expected only in 2011, along with improved labour market. Fiscal consolidation will continue into 2011-2012 (by about 3% of GDP each year). Investment activ- ity will be weak as well, both due to business environment (e.g., uncertainty regarding the likely tax changes) and spare capacity (e.g., in early 2010 ca- pacity utilization was 58% vs. the average of 73% for the pre-crisis period). Investment stabilisation and recovery is forecast in late 2010 or early 201129. Domestic demand to re- main weak, as confidence improvements will be slow to feed into real economic activity It implies weaker demand and, thus, falling turnover, for businesses operat- ing in the domestic market, which requires them to cut costs and prices. They might benefit from cheaper inputs,30 but a substantial part of their in- Deflation aggravates the risk of negative domestic demand spiral 29 Forecast description is available in Swedbank Economic Outlook, see <> 30 For instance, the success story of the wood industry in 2009 to some extent can be attributed to the fact that the state-owned forest management company was offering lower timber-cutting prices, thus allowing manufacturers to sell at lower prices in the world markets at a time when demand was very weak. 10 Swedbank Analysis • March 23, 2010
  11. 11. puts are imported resources, which are gradually becoming more expensive. Higher real interest rates also undermine investments as financing costs in- crease, as well as make deleveraging more difficult (see also 2.5.2). There is a risk of a negative spiral in such an environment – weak domestic demand puts downward pressure on prices, which, in turn, requires additional cost reduction from the business side and thus diminishes demand even more. Currently, effect of the negative domestic demand spiral is lessened by ex- port recovery. To ensure strong export growth is a way to diminish the pain of the internal devaluation scenario. 2.5.2 Deleveraging to deepen The deleveraging process is becoming more visible, and deflation is making it more difficult. As The Economist put it, “deleveraging is an ugly word for a painful process.”31 The excessive leverage built during the boom years (the total credit stock doubled in three years, reaching 100% of GDP in 2007) should be reduced.32 Excessive leverage built up in boom years should be reduced Figure 17. Loans issued to households -2 0 2 4 6 8 1Q 02 1Q 04 1Q 06 1Q 08 -20 0 20 40 60 80 LVL, bn (ls) Annual growth, % (rs) Source: FCMC Figure 18. Loans issued to nonfinancial institutions -2 0 2 4 6 8 10 1Q 02 1Q 04 1Q 06 1Q 08 -20 0 20 40 60 80 100 LVL, bn (ls) Annual growth, % (rs) Source: FCMC The increase in the real burden of debt, or the debt-deflation spiral, was first discussed by Fisher (1933) – he argued that borrowers attempting to reduce their burden of debt engage in distress selling to acquire money to repay their debt. In turn, the massive repayment of debt causes a monetary con- traction and, thus, falling prices. Deflation reinforces indebtedness as debt is specified in current prices and a vicious circle appears. As a result, wealth is redistributed between borrowers and lenders. Later, Minsky (1982) showed that a decrease in collateral value (i.e., asset prices) amplifies these effects. In turn, Bernanke (1983) demonstrated that the vicious circle is also strength- ened by banking system problems (as deflation causes defaults and credit contraction). A similar vicious circle was also explored by Koo (2003) using the example of Japan – he introduced the concept of a balance sheet reces- sion driven by a fall in corporate borrowing (triggered by a fall in asset prices). 31 The Economist, January 16-22 2010. 32 At the end of 2009, the private loan stock (i.e., of households and nonfinancial institutions) in Lat- via was already about 95% of GDP, vs. 105% in the euro area. Higher interest rates in Latvia make debt servicing more difficult. Swedbank Analysis • March 23, 2010 11
  12. 12. Figure 19. Loan overdues, % of total banks’ loan portfolio 0 3 6 9 12 15 18 1Q 06 1Q 07 1Q 08 1Q 09 <30 days >90 days Source: FCMC Figure 20. Loan overdues, % of total banks’ loan portfolio (2009) 0 10 20 30 40 Total Manufacturing Electricity, gas,water Construction Trade Hotels, restaurants Transport, storage, Realestate, otherbus. <30 days >90 days Source: FCMC In the case of Latvia, we see a mix of these effects. Falling wages and em- ployment make debt servicing increasingly tough – a situation that is re- flected in rising loan overdues. Since late 2009 the pipeline of newly arriving overdues is gradually drying up, suggesting a certain stabilisation – both the sharpest drops in economic activity are behind us, also banks and borrowers have got learned to adopt to the situation. Also real estate prices (i.e. also collateral values) pencilling a drop of about 70% from their peak in mid 2007, start to show some stabilisation. Credit stock is slowly falling, as the amount of newly issued loans cannot compensate for the amortization of existing loans. Loan stock is falling, but debt burden rising as in- come fall is steeper Figure 21. EUR weighted average nominal interest rates for existing loan stock, % 3 4 5 6 7 8 Jan.06 Jan.07 Jan.08 Jan.09 Jan.10 Households NFI Source: Bank of Latvia Figure 22. EUR weighted average real interest rates for existing loan stock, % -15 -10 -5 0 5 10 15 Jan.06 Jan.07 Jan.08 Jan.09 Jan.10 Households (CPI deflated) NFI (PPI deflated) Source: Bank of Latvia, CSBL However, the debt burden is increasing both for households and businesses as incomes are declining faster. While lower euro interest rates eased the pressure in 2009 and allowed monthly payments to fall,33 rising real interest rates due to deflation provide incentives for faster repayment of the debt34. Worsening financial situation of the clients impels banks to restructure their loan portfolios, thus postponing the deleveraging process.35 The expected rise in EURIBOR as the global economy recovers will squeeze the borrowers further. Rising interest rates will weigh on debt burden Borrowers’ financial situation largely depends on the sector in which a com- pany operates. Exporting sectors see an increase in demand and prices that helps them to deleverage. The volume of debt as per cent of the sector’s value added has started to shrink in manufacturing; in transport sector debt 33 For instance, the average monthly payment for a household mortgage declined by 20-30%. 34 This typically is impossible due to incomes still falling. 35 Restructuring involves temporarily postponement of payments, extending maturities, etc. 12 Swedbank Analysis • March 23, 2010
  13. 13. burden as per cent of its value added has stopped growing. In turn, domestic demand industries will still be under heavy or even rising pressure. For in- stance, although outstanding credit in the retail trade and wholesale is de- clining, its burden measured against the value added is rising. Situation in the real estate and other commercial services seems better than intuitively ex- pected – debt burden has remained stable for nearly two years, while real es- tate sector was one of the heaviest hit, also the share of overdues is the highest. Such a result, most likely, is due to data aggregation and lag effects – e.g. banks are still to write off the sector’s loses, perhaps the sector’s value added calculations are dominated by commercial services. Figure 23. Corporate credit stock in selected industries Manufacturing 0 50 100 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 0 750 1500 % of value added (ls) LVLm (rs) Retail and wholesale trade 0 25 50 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 0 600 1200 % of value added (ls) LVLm (rs) Transport, storage, communication 0 25 50 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 0 300 600 % of value added (ls) LVLm (rs) Real estate, other business activities 0 75 150 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 0 1500 3000 % of value added (ls) LVLm (rs) Source: FCMC, CSBL The deleveraging process will depend on the access to funding. Credit devel- opments will be determined not only by weak demand (i.e. ability to refi- nance the existing debt and/ or build new leverage, which will ease delever- aging), but also by supply. Similarly to other businesses, banks need to delev- erage as well, which makes them much more cautious in issuing new loans. If banks will remain to be the main (in some cases even sole) source of funding and if there will be no competition for market shares that may motivate at least some of the market participants to lend more actively, deleveraging will be slow. Figure 24. Household mortgage debt burden 10 15 20 25 2006 2008 2010 2012 2014 20 30 40 50 60 Mortgage debt servicing, % of wage bill (ls) Morgage debt, % of GDP (rs) Source: FCMC, CSBL, Sw edbank forecasts Note: based on marekt forecasts, amortization rate assumed stable estimates Figure 25. Debt burden, % of GDP 0 10 20 30 40 50 1Q 02 1Q 04 1Q 06 1Q 08 Household loans NFI loans Source: CSBL, FCMCNFI - Nonfinancial institutions In contrast to the private sector, leverage in the public sector is increasing and will continue to do so, in part due to taking over private sector debt. This also raises future debt servicing for the whole economy, which makes struc- Swedbank Analysis • March 23, 2010 13
  14. 14. tural adjustment even more important to ensure sufficient government tax revenues in the future without the necessity to raise taxes. Global experience shows that deleveraging takes time. Furthermore, it con- tinues to exert some deflationary pressure. Research by the McKinsey Global Institute36 concludes that deleveraging typically takes six to seven years, starting about two years after the beginning of the financial crisis. In Latvia, like in other countries, deleveraging is simply unavoidable. And it will take time37. For instance, our estimates based on fairly standard and across the market by and large similar forecasts regarding GDP, unemployment, wage, interest rate, inflation, portfolio amortisation, credit origination and other variables, suggests that the level of household debt to GDP will return to its 2006 level only in 2013-2014 (see Figure 24). For debt to wage bill ratio it will take even longer. The only way to reduce the stress of deleveraging is to facilitate output growth through supporting export driven growth. Deleveraging will continue exerting additional deflationary pressure 3. POLICY SUGGESTIONS 3.1 How to continue with the chosen scenario? It can be concluded that the internal devaluation process still has a way to go, although a lot has been achieved already. If the scenario continues to be implemented in the way in which it has been done so far, it will become more socially painful, and the situation will not improve quickly, with pressure re- maining on employment and incomes. The still necessary fiscal consolidation provides additional deflationary pressure. However, there is an opportunity to make the adjustment less painful for the economy. One can make the adjustment less painful for the society The aim of the internal devaluation scenario is, through improvements in competitiveness, to increase output. This can be done via cost adjustment, which has been the main tool used so far. Yes, cost reduction aggravates the negative domestic demand spiral, makes deleveraging more difficult, and part of the competitiveness gains are only temporary. But it also provides time for implementing less socially painful structural solutions. The next step, which should be the focus now, is to implement long-overdue produc- tivity-enhancing structural reforms. For businesses this implies, e.g., finding new markets and products and improving the production process. But these changes demand government support. Target increase in output through structural reforms The success of the internal devaluation should not be measured only by CPI- based REER changes. This is one benchmark, but export growth that make the economic structure more balanced, excess productivity gains over wage growth, recovering employment, and an improved financial situation of households and businesses are also important indicators of the successful implementation of the internal devaluation scenario. The faster and stronger is the structural adjustment, the smaller the deflation that will be needed. Competitiveness improvement is a continuous process. Competitiveness im- provement is a continu- ous process 36 The Economist, January 16-22, 2010. 37 An interesting feature of the Latvian economy is high concentration of leverage in selected indus- tries (e.g., real estate developers) and household groups (e.g., those with mortgage loans). For in- stance, about 20% of households have mortgages, while these loans constitute about 80% of total household credit stock. Although for these indebted households deleveraging will be lengthy and painful, majority of households does not have such a debt burden and is able to generate consumption and perhaps new debt. Similarly with real estate developers – a majority of such companies have al- ready gone bankrupt and taken over by banks thus shifting necessity to deleveraging to banks. Con- sequently, if access of financial resources improves (say in addition to banks also risk capitalists, stock market etc), a swifter growth of non-indebted part of the economy will be able to lessen and shorten deleveraging also for those who took the loans during the boom period. 14 Swedbank Analysis • March 23, 2010
  15. 15. 3.2 How to make the adjustment less painful? Structural reforms to be speeded up To make the further adjustment less painful, the authorities should acceler- ate structural reforms and improve the institutional framework. First, it is possible to help businesses to lower costs other than those of la- bour. This strategy implies changing the tax policy and improving the fiscal stance at large (see Kazāks, Strašuna, and Stikuts, 2009, for more details).38 Adopting this strategy would create certainty and strengthen credibility, thus lowering interest rates and improving the investment climate. Another crucial factor is the bolstering of the business environment, which will re- duce costs for businesses by, e.g., lowering administrative barriers. A reflec- tion of an improved business environment would be the establishment of an efficient, fast, and cheap bankruptcy procedure. Second, productivity growth should be stimulated by supporting innovations and ensuring high-quality education. This would help businesses to shift to higher-value-added products. Third, the focus of employment policy should be not only on skills retention, which has been the major approach taken so far, but also on job creation. Here, tax policy may also be employed, for instance, providing temporary la- bour tax allowances for hiring long-term unemployed. And last but not least, capital and financial markets should be made more di- versified to improve availability of financing for businesses (e.g., via venture capitalists, stock market). Those suggestions are not unique or genuinely new. This paper, however, shows from another perspective why structural reforms are so critically nec- essary and why their implementation should not be postponed. Lija Strašuna Mārtiņš Kazāks 38 A more effective policy can also be implemented without being expansionary. Research by Giudice, Turrini, and in’t Veld (2003) shows that fiscal consolidation may actually be followed by accelerating economic growth. Swedbank Analysis • March 23, 2010 15
  16. 16. Abbreviations CPI – Consumer price index CSBL – Central Statistical Bureau of Latvia EA – Eiro area EC – European Commission EE – Estonia EU – European Union FCMC – Financial and Capital Market Commission FTE –Full-time equivalent IMF – International Monetary Fund ls – left scale LT – Lithuania LV – Latvia PPI – Producer price index REER – Real effective exchange rate rs – right scale RULC – Real unit labour costs RUS – Russia SE – Sweden UK – United Kingdom ULC – Unit labour costs References Baig, Taimur (2003), “Understanding the costs of deflation in the Japanese context”, IMF Working Paper WP/03/215, International Monetary Fund Bernanke, Ben (1983), “Non-monetary effects of the financial crisis in propagation of the Great Depression”, American Economic Review 73 (3): 257-76 Bernanke, Ben (2002), “Deflation: Making Sure "It" Doesn't Happen Here”, Remarks by Governor Ben S. Bernanke, Before the National Economists Club, Washington, D.C. Buiter, Willem H. (2003), “Deflation: Prevention and Cure”, NBER Working Paper Series, available at Burdekin, Richard C.K., Pierre L. Siklos (2002), “Fears of deflation and policy responses then and now”, available at SSRN: Decressin, Jorg, Douglas Laxton (2009), “Gauging risks for deflation”, IMF Staff position note, International Monetary Fund Fisher, Irving (1933), “The debt-deflation theory of Great Depressions”, Econometrica 1 (4): 337-57 Fontes (2010). “Fontes Baltic Salary Survey, Latvia”, January 2010 Giudice, G., A. Turrini and J. in’t Veld (2003), "Can fiscal consolidations be expansionary in the EU? Ex-post evidence and ex-ante analysis”, Directorate-General for Economic and Financial Affairs, Economic Paper of the European Commission No. 195 International Monetary Fund (IMF) (2003), “Deflation: Determinants, risks, and policy options – findings of an independent task force”, April 2003 International Monetary Fund (IMF) (2006), “Republic of Latvia: 2006 Article IV Consultation – Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Latvia”, IMF Country Report No. 06/353, October 2006 International Monetary Fund (IMF) (2009), “Republic of Latvia: Request for Stand-By Arrangement – Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Latvia”, IMF Country Report No. 09/3, January 2009 Kazāks, Mārtiņš, Liene Kūle, Lija Strašuna (2006), “Eiro ieviešana Latvijā: riski un iespējas” (“Euro introduction in Latvia: risks and opportunities”, available in Latvian only), Hansabanka Analytical Discussions, February 2006 Kazāks, Mārtiņš, Lija Strašuna, Dainis Stikuts (2009), “Fiscal stance in Latvia – how to return to a sustainable path?”, Swedbank Analysis, October 2009, available at Koo, Richard (2003), Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications, John Wiley & Sons, Singapore 2003 Minsky, Hyman (1982), “Debt-deflation processes in today’s institutional environment”, Banca Nazionale del Lavoro Quarterly Review, December 16 Swedbank Analysis • March 23, 2010
  17. 17. Economic Research Department Sweden Cecilia Hermansson +46 8 5859 1588 Group Chief Economist Chief Economist, Sweden Magnus Alvesson +46 8 5859 3341 Senior Economist Jörgen Kennemar +46 8 5859 1478 Senior Economist Helena Karlsson +46 8 5859 1028 Assistant Estonia Maris Lauri +372 6 131 202 Chief Economist, Estonia Elina Allikalt +372 6 131 989 Senior Economist Annika Paabut +372 6 135 440 Senior Economist Latvia Mārtiņš Kazāks +371 67 445 859 Deputy Group Chief Economist Chief Economist, Latvia Dainis Stikuts +371 67 445 844 Senior Economist Lija Strašuna +371 67 445 875 Senior Economist Lithuania Lina Vrubliauskienė +370 5 268 4275 Chief Economist, Lithuania Ieva Vyšniauskaitė +370 5 268 4156 Senior Economist Swedbank Analysis • March 23, 2010 17
  18. 18. Disclaimer This research report has been prepared by economists of Swedbank’s Economic Research De- partment. The Economic Research Department consists of research units in Estonia, Latvia, Lithuania, and Sweden, is independent of other departments of Swedbank AB (publ) (“Swed- bank”) and responsible for preparing reports on global and home market economic developments. The activities of this research department differ from the activities of other departments of Swedbank, and, therefore, the opinions expressed in the reports are independent of interests and opinions that might be expressed by other employees of Swedbank. This report is based on information available to the public that is deemed to be reliable, and re- flects the economists’ personal and professional opinions of such information. It reflects the economists’ best understanding of the information at the moment the research was prepared; due to changes of circumstances, such understanding might change accordingly. This report has been prepared pursuant to the best skills of the economists, and, with respect to their best knowledge, this report is correct and accurate; however, neither Swedbank nor any enterprise belonging to Swedbank or Swedbank directors, officers, or other employees or affili- ates shall be liable for any loss or damage, direct or indirect, based on any flaws or faults within this report. Enterprises belonging to Swedbank might have holdings in the enterprises mentioned in this re- port and provide financial services (issue loans, among others) to them. The aforementioned cir- cumstances might influence the economic activities of such companies and the prices of securi- ties issued by them. The research presented herein is of an informative nature. This report should in no way be inter- preted as a promise or confirmation of Swedbank or any of its directors, officers, or employees that the events described in the report shall take place or that the forecasts turn out to be accu- rate. This report is not a recommendation to invest into securities or in any other way enter into any financial transactions based on the report. Swedbank and its directors, officers, or employees shall not be liable for any loss that might be suffered as a result of relying on this report. We stress that forecasting the developments of the economic environment is somewhat specu- lative in nature and that the real situation might turn out different from what this report pre- sumes. IF YOU DECIDE TO OPERATE ON THE BASIS OF THIS REPORT, THEN YOU ACT SOLELY AT YOUR OWN RISK AND ARE OBLIGED TO VERIFY AND ESTIMATE THE ECONOMIC REASONABILITY AND THE RISKS OF SUCH ACTION INDEPENDENTLY. 18 Swedbank Analysis • March 23, 2010