Mārtiņš Bitāns. Lessons from the Latvian austerity program

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Mārtiņš Bitāns (Latvijas Banka) "Latvian economy: challenges of the recent austerity programme and of acceding to the euro area" Public lecture at the Eesti Pank Museum 18.04.2013

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Mārtiņš Bitāns. Lessons from the Latvian austerity program

  1. 1. Lessons from the Latvian austerity program Martins Bitans Bank of Latvia 18 April 2013 1
  2. 2. Expansionary fiscal contraction• Giavazzi, Pagano (1990): The Danish experience shows that cuts in government spending can be associated with increases in consumption;• Blachard (1990): Sometimes, decrease in spending or an increase in taxes indeed increases demand, consumption and output. The questions are that of when and how;• Alesina and Ardagana (1997): Fiscal tightening produces (non-Keynesian) expansionary effects. One interpretation is that a serious fiscal tightening increases demand;• Alesina and Perotti (1998): Fiscal corrections relying mostly on spending cuts that are concentrated on government wages and transfers tend to be expansionary ;• Alesina and Ardagana (2009): We uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions. 2
  3. 3. Expansionary fiscal contraction : critique• IMF WEO (October 2010): Fiscal consolidation typically reduces output and raises unemployment in the short term. Over the long term, reducing government debt is likely to raise output.• DeLong and Summers (2012):Need for considerable caution re- garding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound• Blanchard and Leigh (2013): Stronger planned fiscal consolidation associated with lower growth than expected.• Krugman (2010): What sounds like hardheaded realism actually rests on a foundation of fantasy, on the belief that invisible vigilantes will punish us if we’re bad and the confidence fairy will reward us if we’re good. 3
  4. 4. Fiscal Policy Changes and Economic Growth in Latvia 10.0 5 5.0 2.5 0.0 0 Cyclically adjusted -5.0 -2.5 government balance (% of GDP), RHS -10.0 -5 -15.0 -7.5 GDP growth (%), LHS -20.0 -10 2008 2009 2010 2011 2012 2013 (f)Source: EC, CSB Latvia 4
  5. 5. HAS FISCAL AUSTERITY WORKED INLATVIA? 5
  6. 6. Main problem of the boom years – unsustainable current account position Savings, Investments and Current Account Balance in Latvia (% of GDP) • Current account (by identity) is40.0 the difference between30.0 income and consumption, but also the difference between20.0 domestic savings and investment10.0 0.0 • Current account deficits can be-10.0 reduced by increasing savings (lower consumption) or lower-20.0 investments-30.0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 • Both approaches imply GDP Current account Savings Investments will inevitably decline 6
  7. 7. In two years from 2008-2010, GDP declined by almost a quarter… Real GDP, 4 quarter moving average (1Q 2007=100)110.0105.0100.0 95.0 90.0 85.0 80.0 2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 7
  8. 8. … but much of it was correcting for previous (unsustainable) excesses Real GDP, 4 quarter moving average (1Q 2000=100)200.0175.0150.0 Actual GDP125.0 Long-term trend100.0 75.0 8
  9. 9. Assessing devaluation options104102100 GDP with fixed peg: IMF assessment98 GDP with wider96 fluctuation bands: IMF94 assessment GDP with wider92 fluctuation bands: BoL assessment9088 2008 2009 2010 2011 2012 2013 9
  10. 10. Structure of Domestic Loans (%)100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2011 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 LVL EUR USD other 10
  11. 11. Impact of devaluation on the banking system45 43.640353025 23.820 1715 12 12.410 7.2 6 5 0 0 -5-10 -5.6 Share of loans overdue (more Capital adequacy ratio Number of banks with CAR than 90 days) lower than 8% As of 30.06.09 With 15% devaluation With 30% devaluation 11
  12. 12. 0 1 3 4 5 6 2 -7 -6 -5 -4 -3 -2 -1 LatviaSource: Eurostat Lithuania Estonia Poland Slovakia Bulgaria Malta Austria Sweden Germany Ireland Romania Luxembourg United Kingdom France Belgium Finland European Union Denmark GDP growth in 2012 (% y-o-y) Netherlands Czech Republic Spain Hungary Slovenia Italy but this time with sound fundamentals Cyprus Portugal Greece 12 Today Latvia is again the fastest growing EU country,
  13. 13. Average annual growth in 2004-2014: Latvia 3.4% vs Iceland 2.3% GDP growth, % 15.0 10.0 5.0 0.0 Latvia -5.0 Iceland -10.0 -15.0 -20.0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 (F) (F) 13Source: Eurostat
  14. 14. 95 100 105 110 115 120 125 130 135 140 145 150 2004Q1 2004Q4 2005Q3 2006Q2 2007Q1 2007Q4 2008Q3 2009Q2 2010Q1 2010Q4 2011Q3 2012Q2 2013Q1 2013Q4 (1Q 2004=100) 2014Q3 2015Q2 2016Q1 2016Q4 Real GDP: Latvia vs Iceland Latvia Iceland14
  15. 15. WHY HAS FISCAL AUSTERITYWORKED IN LATVIA? 15
  16. 16. Blanchard (1990)• Fiscal consolidation has two effects: – increases tax burden and reduces consumption (strength depends on how far economy departs from Ricardian equivalence) – by reducing deficit today the government eliminates the need for more adjustments in the future• When would expect a fiscal consolidation to increase rather than decrease output? – when the first effect dominates the second• This is more likely under two conditions: – small effects of intertemporal tax reallocation • consumers more Ricardian if credit markets developed – when the economy is closer to the brink (of insolvency) • debt approaching critical levels 16
  17. 17. Bond yields vs government debt in 2009 14.00Government long-term bond yields 12.00 LV 10.00 8.00 (%) 6.00 4.00 2.00 0.00 30.0 35.0 40.0 45.0 50.0 55.0 Government debt (% of GDP) 17
  18. 18. Debt projections for Latvia: where is the critical threshold? 140 120 100 Public sector debt 80 Scenario under the 60 program adjustment 40 Scenario with no policy change 20 0 18Source: IMF, First Review under IMF Stand-By Agreement; September 2009
  19. 19. 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 2006M01D02 2006M03D08 2006M05D12 2006M07D18 2006M09D21 2006M11D27 2007M01D31 2007M04D06 2007M06D12 2007M08D16 2007M10D22 2007M12D26 2008M02D29 2008M05D06 2008M07D10 2008M09D15 2008M11D19 2009M01D23 2009M03D31 2009M06D04 2009M08D10 2009M10D14 2009M12D18 2010M02D24 2010M05D13 2010M07D28 2010M10D04 2010M12D09 2011M02D16 2011M04D26 2011M07D05 2011M09D08 2011M11D17 2012M01D25 2012M04D03 2012M06D13 2012M08D17 2012M10D23 2013M01D03 bonds: Latvia vs Germany Yields on long-term government Latvia19 Germany
  20. 20. General Government budget balance (ESA’95), % of GDP 0 -2 -0.8 -1.3 -0.9 -4 -1.6 -2.9 -3.1 -6 -5.6 -8 -6.9 -6.4 -10 -12 -14 -16 -18 -20 2005 2006 2007 2008 2009 2010 2011 2012F 2013F 2014F Consolidation effort Actual (targeted) balance Structural budget balance (PF) 20 20Source: Eurostat, F – Bank of Latvia staff estimation
  21. 21. Breakdown of budget consolidation measures, % of GDP 21Source: Ministry of Finance; Bank of Latvia staff calculations
  22. 22. ULC adjustment through lowerwages, but also higher productivity Unit labour cost index (2000 Q1 = 100; seasonally adjusted)240 -23%200160 -28%120 80 2000 Q1 Q3 2001 Q1 Q3 2002 Q1 Q3 2003 Q1 Q3 2004 Q1 Q3 2005 Q1 Q3 2006 Q1 Q3 2007 Q1 Q3 2008 Q1 Q3 2009 Q1 Q3 2010 Q1 Q3 2011 Q1 Q3 2012 Q1 Nominal ULC Real ULC 22
  23. 23. 20 40 60 80 0 100 20 60 80 40 100 0 Denmark Austria Sweden Belgium Finland Slovenia Cyprus Portugal Malta France Belgium Finland Luxembo… SwedenSource: www.worker-participation.eu Slovenia Netherl… Austria Greece Ireland Spain Italy Denmark Greece Italy Romania Cyprus Slovakia Germany United… Luxemb… Czech… Malta Trade union density, % Germany Czech… Netherlan… Ireland Bulgaria Collective bargaining coverage (%) Poland Hungary Slovakia 16 Latvia United… Poland Romania Spain Bulgaria Portugal Estonia flexible labour market framework Lithuania Hungary 20 Estonia Latvia Adjustment in economy supported by 23 France Lithuania
  24. 24. Economic and export growth underpinned by restored competitiveness as wage-productivity gap has been closed Wage and productivity index (2005 Q1 = 100, seasonally adjusted) 150 130 110 90 Labour productivity Real wage 70 2000 Q1 Q3 2001 Q1 Q3 2002 Q1 Q3 2003 Q1 Q3 2004 Q1 Q3 2005 Q1 Q3 2006 Q1 Q3 Q3 2008 Q1 Q3 2009 Q1 Q3 2010 Q1 Q3 2011 Q1 Q3 2012 Q1 Q3 2007 Q1 24Source: Central Statistical Bureau of Latvia data, Bank of Latvia staff calculations (2012 Q4: flash productivity data)
  25. 25. Exports in Latvia growing faster than in countries where currency depreciated Exports of goods and services (in euros), 2006=100180.0160.0 Latvia140.0 Sweden120.0 United Kingdom Iceland100.0 Poland 80.0 Estonia 60.0 2006 2007 2008 2009 2010 2011 25
  26. 26. CAN FISCAL AUSTERITY WORKELSWHERE? 26
  27. 27. All PIIGS countries had vulnerable government debt positions 60 IE LV Hazard Expected changes in governmnt debt 50 zone 40 (% of GDP), 2009-2016 PT 30 US SP GR 20 UK FR 10 BE IT 0 0 20 40 60 80 100 120 140 -10 -20 Hazard -30 zone Government debt in 2009 (% of GDP)Source: IMF WEO April 2010 27
  28. 28. Potential credibility gains before adjustment: largest in Greece, smallest in Italy 10 LV Spreads on government bond yields 8 vis-a-vis Germany (% points), 2010 GR 6 4 IE PT ES 2 IT 0 0 20 40 60 80 100 120 140 -2 -4 Government debt (% of GDP), 2009Source: IMF 28
  29. 29. 4. Relationship between Government Debt and Bond Yields in Selected European Countries 8.00 7.00 10 Y Government bond yields 6.00 CEEC 5.00 4.00 . 3.00 Advanced 2.00 EU 1.00 0.00 0 20 40 60 80 100 120 . Expected gross government debt in 2017 (% of GDP) 29Source: Eurostat, ECB, IMF
  30. 30. When does Keynesianism work?• Total demand in the economy significantly below total supply – in Latvia, both demand and supply contracted• Extra government spending can be financed – Latvia had not accumulated budget surpluses during the boom years – markets were not able or willing to finance government spending almost at any cost• Stable money demand – in Latvia, national and foreign currencies are close substitutes• Relatively closed economy – in Latvia, imports account for a significant share of total income 30
  31. 31. How counter-cyclical was fiscal policy during the boom years Structural budget deficit (average 2004-2008, % of GDP) 0 -1 -2 -3 -4 -5 -6 -7 -8 Spain Ireland Latvia Italy Portugal GreeceSource: EC 31
  32. 32. Countercyclical fiscal policy must be countercyclical throughout the cycle, not just during the downturn 7 GR 6 Changes in structural balance 2013-2011 5 IT 4 PT RO PL 3 (% of GDP) FR ES HU LT SK CY SI 2 NE DE IE CZ BE 1 BG UK MT LV AU EE 0 FI LU SE DK -1 -8 -6 -4 -2 0 2 4 Average structural balance 2004-2008 (% of GDP) 32Source: EC
  33. 33. Labour market flexibility Collective bargaining coverage (% labour force) 100 90 80 70 60 50 40 30 20 10 0 Latvia Ireland Greece Spain Italy Portugal 33Source: www.worker-participation.eu
  34. 34. Openess to foreign trade Exports and imports of goods and services (% of GDP) 200 180 160 140 120 100 80 60 40 20 0 Latvia Ireland Greece Spain Italy PortugalSource: Eurostat 34
  35. 35. Estimating chances of expansionary fiscal consolidation Debt Spread Flexibility Openness Frontloading TOTAL before before of labour to trade of fiscal adjustment adjustment markets adjustmentLatvia HIGH 36.7 9.14 20 126 6.4Ireland HIGH 92.2 3.0 35 192 6.2Portugal MEDIUM 93.5 2.66 94 77.9 4.8Italy LOW 119 1.3 80 59.4 1.6Greece MEDIUM 148 6.35 85 59 4.1Spain LOW 61.5 1.51 82 63.8 -0.5 35
  36. 36. A LOOK INTO THE FUTURE 36
  37. 37. 2.4 2.6 2.8 3 3.2 3.4 3.6 3.8 4 nov.11 dec.11 jan.12 feb.12 mar.12 apr.12 mai.12 jūn.12 jūl.12 aug.12 sep.12 okt.12 nov.12 for Latvia (%) dec.12 jan.13 feb.13 mar.13 EC IMF Forecasts of GDP growth in 201337 Consensus
  38. 38. Economic growth in Latvia generated by exports and private consumption Contribution to GDP growth (% points) 25 20 Imports 15 10 Exports 5 0 Investments -5 -10 -15 Government -20 consumption -25 Private consumption -30 -35 GDP -40 2005 2006 2007 2008 2009 2010 2011 2012Source: Statistics Latvia 38
  39. 39. Decline in credit stock reflects still ongoing deleveraging Credit to private sector (y-o-y, %) 100 80 60 40 20 0 -20 I 2011 IV IV IV IV IV IV IV IV IV X X X X X X X X X I 2004 I 2005 I 2006 I 2007 I 2008 I 2009 I 2010 I 2012 I 2013 VII VII VII VII VII VII VII VII VII Annual growth of household credit stock Annual growth of nonfinancial corporation credit stock Annual growth of resident credit stock (without government) 39Source: Bank of Latvia
  40. 40. Deleveraging in the banking system continues, limits loan growth Loan-to-Deposit Ratio in Latvia (%) Loan growth in Latvia (%) 350 50 40 300 30 250 20 10 200 - 150 -10 -20 100 I VII I VII I VII I VII I VII VII VII VII VII VII VII VII VII I 2005 I 2006 I 2007 I 2008 I 2009 I 2010 I 2011 I 2012 2008 2009 2010 2011 2012 Contribution to lending growth by foreign banks (% Total Foreign banks points) Contribution to lending growth by domestic banks (% Domestic banks points) Total lending growth (%)Source: Bank of Latvia 40
  41. 41. Confidence indicators strong, but for how long? Economic Sentiment Index (ESI) 115 110 Latvia 105 100 95 Lithuania 90 85 Estonia 80 I V IX I V IX I V IX I 2010 2011 2012 2013 41Source: EC
  42. 42. Euro: why now? 42
  43. 43. Maastricht reference value for price stability will be reached with a significant margin in Latvia Estimates of 12 month average inflation and the Maastricht criterion, %4.54.03.53.0 2.92.52.01.5 1.61.0 V V VII X XII VII X XII II II IX IV IX IV III III IV 2011 VI VIII XI VI VIII XI I 2012 I 2013 12m average inflation in Latvia Estimated Maastrich criterion*Sources: Eurostat, EC, Bank of Latvia estimates * - Greece excluded from calculation 43
  44. 44. Actual and estimated inflation: Latvia vs EU best inflation performers (%) Jan.13 Feb.13 Mar.13 Apr.13*Annual inflation Latvia(%) 0.6 0.3 0.3 0.412 month average inflation in Latvia (%) 2.05 1.81 1.57 1.3612 month HCPI inflation (%):Sweden 0.93 0.89 0.84 0.80Ireland 1.95 1.92 1.78 1.68Germany 2.11 2.05 2.01 1.98Denmark 2.22 2.08 1.91 1.78France 2.13 2.02 1.89 1.78Maastricht criterion (Greece assumed as outlier) 3.1 3.0 2.9(%) 2.8 (SE, IR, (SE, LV, (SE, LV, (SE, LV, IR) LV) IR) IR) * BoL forecasts 44
  45. 45. Interest rate criterion scenario analysis Jan.13 Feb.13 Mar.13* Apr.13*12 month average interest rates in Latvia (%) 4.35 4.17 4.00 3.8412 month average interest rates (%):Sweden 1.60 1.61 1.61 1.63Ireland 5.88 5.61 5.35 5.09Germany 1.47 1.44 1.42 1.41Denmark 1.39 1.38 1.37 1.37France 2.45 2.39 2.33 2.27Maastricht criterion (LV, SE, IR), % 5.94 5.80 5.65 5.52Maastricht criterion (LV, SE), % 4.98 4.89 4.81 4.74Maastricht criterion (LV, SE, FR), % 4.80 4.72 4.65 4.58Maastricht criterion (LV, SE, DK), % 4.45 4.39 4.33 4.28 * BoL forecast 45
  46. 46. Contribution of main components to the annual average inflation, pp 3 2.6 2.4 3 2.3 2 Fuel 2 1.3 Unprocessed food Regulated prices 1 Core inflation Annual average inflation 1 0 -1 2012 2013 2014 2015 46Source: Central Statistical Bureau of Latvia, forecast - Bank of Latvia staff estimation
  47. 47. Euro zone’s policy response to crisis POLICY AREA BEFORE THE CRISIS NOWMonetary policy Liquidity support Lender of last resortCoordinated financial None European Stabilityassiatance MechanismFiscal policy Stability and growth Enhanced SGP (Fiscal pact (SGP) Compact, European Semester)Banking National supervision Coordinated supervision (banking union in the future?) 47
  48. 48. Policy coordination is good but market discipline is essential 2008 2012 9.00 9.0 8.00 8.0 Government bond yields (%)Government bond yields (%) 7.00 7.0 6.0 6.00 5.0 5.00 4.0 4.00 3.0 3.00 2.0 2.00 1.0 1.00 0.0 0.0 25.0 50.0 75.0 100.0 125.0 0.0 25.0 50.0 75.0 100.0 125.0 Government debt (% of GDP) Government debt (% of GDP) 48
  49. 49. Summary: costs and benefits of joining versus waiting Latvia joins the euro in 2014 Latvia waitsBanking sector problems solved, •Latvia benefits from lower •Higher interest rates hampergrowth in the euro zone picks interest rates, additional growth.up investment •Risks of marginalizationEuro zone continues “muddling •Lower interest rates •Uncertainty leads to higherthrough” the crisis •Participation in EMS, but interest rates money not lost •Ultimately costs of joining •Latvia paticipates in designing (EMS) the same or higher euro zone policies •Will adopt policy framework which was designed without LatviaEuro zone disintegrates •Latvia suffers severe macro •Latvia suffers severe macro consequences consequences •Extra costs of currency re- introduction •Some payments into EMS may be lost 49

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