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Swedbank Analysis No.5 - June 8, 2012


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Swedbank Analysis - June 8, 2012:
“Against the Odds – Lessons from the Recovery in the Baltics”

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Swedbank Analysis No.5 - June 8, 2012

  1. 1. Swedbank Analysis Nr 5  8 June 2012 “Against the Odds – Lessons from the Recovery in the Baltics” In Riga on June 5th, the Bank of Latvia jointly with the International Monetary Fund (IMF) organised a conference celebrating the completion of Latvia’s IMF and EU supported program. The conference reviewed the policies that helped Latvia, Estonia and Lithuania emerge from the deep recession and also discussed the remaining challenges, as well as lessons for policy makers elsewhere. Swedbank’s Chief Economist, Cecilia Hermansson, was invited to speak at the conference. Other speakers included Christine Lagarde, Managing Director, IMF; Valdis Dombrovskis, Prime Minister of Latvia; Anders Borg, Minister of Finance, Sweden; Oliver Blanchard, Chief Economist, IMF; Ingrida Simonyte, Andris Vilks and Jurgen Ligi, Ministers of Finance from Lithuania, Latvia and Estonia; Jörg Asmussen, Executive Board Member, ECB; Olli Rehn, European Commissioner for Economic and Financial Affairs, EC; and Ilmars Rimsevics, Governor, Bank of Latvia. Below, find the speech delivered by Cecilia Hermansson while participating under the second session: Looking ahead: The remaining challenges for Latvia and the Baltics. Ladies and Gentlemen, Thank you for inviting me to participate in this very interesting high- level conference, celebrating Latvia’s completion of the IMF and EU- supported program, and, so far, all three Baltic countries’ successful recovery. The Baltic economies went through an extreme cycle of growth up to 2007, and then a very steep decline in 2008 and 2009. The conver- gence since the 1990s has been impressive, even if we realize that growth rates gradually became unsustainable, driven by an excess in credit expansion and too much speed in domestic demand. Swedish banks, including Swedbank, aggravated the crisis, and have learnt many lessons, not least about lending principles and risk manage- ment. But to make it clear, it was never an option for Swedish banks to leave the Baltic region. The recovery since the crisis has also been impressive: high growth, strong budget consolidation, deleveraging, cost cutting and internal devaluation, the government’s successful issuing of bonds, current account surpluses and increased competitiveness – developments that would not have been possible without strong commitments and Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 7740e-mail: Internet: Responsible publisher: Cecilia Hermansson +46 (0)8-5859 7720. Magnus Alvesson +46 (0)8-5859 3341, Jörgen Kennemar +46 (0)8-5859 7730 ISSN 1103-4897
  2. 2. crisis awareness. Despite expectations of many academics and fi-nancial analysts, the exchange rate peg has held, and Estonia haseven made it into the euro area. For Latvia, the support from IMF andEuropean partners has been crucial for its success, although I believethe program would not have worked without the active involvementand strong commitment of Latvia’s policy makers and population.GDP-levels, Index 2000 = 100 190 Latvia 180 170 Lithuania 160 150 Index 2000=100 140 130 Estonia 120 110 Eurozone 100 90 80 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11Source: Ecowin, National Statistics.The deep recession has brought with it great economic and socialcosts, such as high unemployment, increased poverty, emigration,and an overhang of private debt. GDP levels are not yet back at pre-crisis levels. The crisis in the euro area is now jeopardising the re-covery in the Baltics. While acknowledging the great efforts and suc-cess achieved by the Baltic countries, it is equally important that wefocus on the vulnerabilities that remain and the challenges that mustbe dealt with in order to sustain the recovery and continue improvingcompetitiveness.As it made sense for Estonia to become a member of the euro area, italso makes sense for Latvia and Lithuania. For these countries, whichhave for a long time maintained a fixed exchange rate regime, takingthe step towards full membership means access to a larger capitalmarket, increased stability and participation in euro area policymak-ing. This, I believe, outweighs the possible drawbacks of giving upflexibility in monetary policy. However, GDP per capita and price lev-els are below the euro area average, and convergence will take time;it will not even be automatic as may have been believed some 7-8years ago. The most important is to avoid reform fatigue and to focuson structural reforms that safeguard budget discipline and high pro-ductivity growth.2 Swedbank Analysis No 5 • 8 June 2012
  3. 3. GDP per capita, EU-27 = 100 120 100 80 60 40 20 0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Eurozone Estonia Latvia LithuaniaSource: Eurostat.I will concentrate my discussion on three main challenges: 1) makingthe most of globalisation and closing the productivity gap, 2) adaptingto demography and labor market trends, and 3) the need tostrengthen institutions.Market share developments (goods exports), Index 2001 = 100 200 LT 180 160 DE 140 EE 120 SK 100 LV 80 SE 60 40 FISource: Eurostat.All three Baltic countries have been successful in gaining marketshare over the last decade. Latvia and Lithuania, especially, have in-creased their export markets almost in line with Slovakia, while Swe-den and Finland have lost market share. Vertical specialisation andlabour division within the Baltic Sea region has been important, but,going forward, countries need to intensify knowledge-based intra-trade and horizontal integration in order to improve national and re-gional competitiveness in both a European and a global context. TheBaltic countries are at a cross roads, and should avoid competingwith low-cost production, and instead strive to move up the value-added chain.Swedbank Analysis No 5 • 8 June 2012 3
  4. 4. It is therefore important to close the productivity gap, which is some50 % at the moment. Especially in Latvia, the to-do the list is long.The value added in manufacturing is only 45 % of the 27 EU-countries average. Innovation expenditures in business are low andgross expenditures in R & D and patents rank almost last out of the27 EU countries.The same applies to competitiveness, as measured by the WorldEconomic Forum. While Latvia ranks 70th out of 139 countries, onlyGreece and Bulgaria rank lower within the European Union. Thesituation is somewhat better when analysing trade and externalopenness, and especially when taking note of the World Bank’s “easeof doing business” survey, where all three countries rank high in sup-porting flexibility and the entrepreneurial spirit.Closing the Productivity Gap Estonia Latvia LithuaniaValue Added in Manufacturing, % av EU27 (2010) 67 45 73Gross Domestic Expenditures on R & D, ranking of EU27 (2010) 14 24 20Patents, ranking of EU27 (2009) 16 23 26Competitiveness (WEF), ranking of 139 countries (2011/2012) 33 70 47Competitiveness (WEF), of EU27 (2011/2012) 12 25 19Enabling Trade (WEF), ranking of 132 countries (2012) 26 52 45Ease of Doing Business (WB), ranking of 183 countries (2012) 24 21 27Source: Eurostat, World Economic Forum (WEF), World Bank (WB)Going forward, a faster increase in real wages than in productivityneeds to be avoided. What is making the situation more difficult,however, is the adverse demographic situation, which is driven by lowfertility, aging, and the combination of heavy emigration and light im-migration.Population forecasts show a steep decline, with an added burden onthe young and the social welfare system. The declining population isreducing the labour force and, in turn, lowering savings. A decreasingnumber of economically active people is tightening the labour market,which can lead to rising wages. The changing size and structure ofthe population can also weaken demand, especially in such sectorsas housing and infrastructure.4 Swedbank Analysis No 5 • 8 June 2012
  5. 5. Population forecast to 2050 4,0 Lithuania 3,5 3,0Person (millions) 2,5 Latvia 2,0 1,5 Estonia 1,0 0,5 50 60 70 80 90 00 10 20 30 40 Source: Bureau of Census, International Data Base (IDB)All of these trends are putting downward pressure on economicgrowth. In addition, an older labour force is less geographically andoccupationally mobile and is less able to adapt to economic changes– something that might be a threat to innovation. Allowing and en-hancing immigration could over time contribute to a more dynamicsociety, as new people also bring new ideas. Also, supporting menand women balancing work life and family life is important.Swedbank Analysis No 5 • 8 June 2012 5
  6. 6. Despite high unemployment, companies are finding it difficult to findcompetent labour in certain sectors. It is important to strengthen thedriving force to participate on the labour market. It is also important tomatch educational attainment to labour market needs – to do this, itwill be necessary to close the gap between academia and the busi-ness community, which is large. And, while education performance isgenerally above the EU average, it needs to align better with busi-ness’ needs and move up further towards EU benchmarks.Unemployment rates, % 22,5 Latvia 20,0 17,5 15,0 Procent 12,5 Lithuania Estonia 10,0 7,5 5,0 2,5 04 05 06 07 08 09 10 11 Source: Reuters EcoWinSource: Ecowin, National Statistics.One of the main factors for success in countries’ performance seemsto be the strength of institutions, creating confidence and making iteasier for households, investors, and business actors to predict thefuture. Latvian companies, in answering the World Economic Forumquestionnaire on the most problematic factors for doing business,mention tax regulations, inefficient government bureaucracy, and lowaccess to financing.Also, corruption is mentioned by a number of companies, more fre-quently than in most other EU countries. Low public trust in politi-cians, wasteful government spending, low efficiency in the legalframework, and the large extent and effect of taxation are factorsranking among the lowest in the world of some 110-120 out of 139countries. The commissioning of external experts to prepare a com-petitiveness report for Latvia is therefore much welcome.6 Swedbank Analysis No 5 • 8 June 2012
  7. 7. Indicators regarding institutions, Competitiveness Report 2011/2012 140 135 130 127 125 125 120 117 118 119 117 120 116 115 110 104 101 105 100 95 90Source: World Economic Forum.There is a strong link between strengthening institutions in general,increased transparency, tax payments and the financial sector per-formance, which according to the chart here needs much improve-ment. The crisis has decreased lending, perhaps more due to the de-leveraging lowering the demand for new credits than more restrictivelending policies. A normalisation will come, as is starting to be visiblein Estonia, but the situation is still fragile, not least due to the crisis inthe euro area. For start-ups, there is a need to build new institutionswith cooperation between the banking sector and the governmentstimulating venture capital and financing through local equity markets.But without transparency and a reduction of the grey market econ-omy, it will be difficult to be successful in strengthening the financialsector.A crisis is a terrible thing to waste! I believe the Baltic countries havenot wasted this crisis, but with the challenges remaining, the speed ofreform must be kept up, and the mistakes of Greece and Portugalmust not be repeated. A fixed exchange rate means focusing more onbudget discipline and competitiveness, and not least maintaining thespeed and ambitions of structural reforms.Thank you!Swedbank Analysis No 5 • 8 June 2012 7
  8. 8. Economic ResearchDepartment Swedbank Analysis is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of theSE-105 34 Stockholm analyses reported in this publication. However, we cannot guarantee theTelephone +46-(0)8-5859 7740 accuracy or completeness of the report and cannot be held responsible any error or omission in the underlying material or its use. Readers are en- couraged to base any (investment) decisions on other material as well. Nei-Legally responsible publisher ther Swedbank nor its employees may be held responsible for losses orCecilia Hermansson, damages, direct or indirect, owing to any errors or omissions in Swedbank+46-8-5859 7720. Analysis.Magnus Alvesson, +46-8-5859 3341Jörgen Kennemar, +46-8-5859 7730ISSN 1103-4897