Latvia is a country located in Northern Europe with a population of 2.2 million. Its economy relies heavily on exports, which account for over 60% of GDP. During an economic crisis from 2008-2010, Latvia experienced a severe recession with GDP contracting over 10% and unemployment rising to nearly 19%. To recover without devaluing its currency pegged to the euro, Latvia implemented an "internal devaluation" through fiscal austerity, wage cuts, and boosting competitiveness. By focusing on exports and structural reforms, Latvia was able to recover faster than other crisis-hit countries and regain financial stability and investment grade credit ratings.

1. Latvia
Overview of Country Profile.
Analysis of Extract 3

2. Location
• North-East Europe
• One of the three Baltic
States
• Capital: Riga
• Land Mass: 64 500 km2
• Population: 2.2 million
• Historical dependency of:
Germany, Poland,
Sweden, USSR
• Independence: 1919-
1941; 1991 - present

3. Demographics
• Shrinking Population:
Low Birth Rate
- Fertility: 1.35 – 221nd globally
EU Migration
• Ethnic Split:
61% Latvians
28% Russians
3% Belarusian

4. Composition of GDP
• Services: 70%
– IT
– Transport
– Wholesale
– Finance
• Manufacturing: 25%
– Timber
– Foodstuffs
– Petrochemicals
– Metals
– Pharmaceuticals
– Construction
– Candles
• Agriculture 5%
– Dairies
– Cereals
– Potatoes
– Meat

5. Standards of Living
• GDP per Capita: $21 920
GDP per Capita

6. HDI
• Index: 0.814
• Very High Income
Group

7. 2002-2007
• GDP (PPP): $33.7bn
• Real Growth Rate: 4%
• Causes:
– EU Accession 2004
– Interest Rates
– Business Confidence
– Housing Market
– Consumption Boom
– Credit Boom:
Inventories/Durables
– Asset Price Bubble

8. GDP
Growth
Economic Crisis • Quarterly Contraction:
10.5%
• Output Gap: 10%
• Inflation: 18%
• Unemployment: 18.6%
• Credit Tightening
• Debt: 50% GDP
• Fitch: A+ to BBB-
• Deposit run-on
• Liquidity shortage
• 36-month Stand-By: €7.5bn

9. • Aims of Bailout (Conditionality):
– stem the loss of bank deposits and international
reserves
– restore confidence in the banking and support
private debt restructuring;
– limit the substantial widening in the budget deficit
– prepare for early fulfillment of the Maastricht
criteria
– Structural reforms aimed at rebuilding
competitiveness

10. Resolution
• Conventional method: budgetary squeeze, followed by
offsetting stimulus of a currency devaluation
• Latvia’s Aim: Restore Financial Stability
– Fiscal Adjustment: 17.5%
– Swiftness: Bulk Done in 2009
• Focus: Export-led Local Recovery
• Corporation Tax stable: 15%
– Real Tax Rate: 2 ↓to 36%
– Emigration
• Internal Devaluation

11. Internal Devaluation
• Fixed Exchange Rate
– Counter-Cyclical Expansionary Policy
– Large Euro-denominated Debt Stocks

12. • Taxation in-
payments fell 3
to 13%
• Revenue stable:
26±1% of GDP
• Short-Term pain:
Pro-cyclical Fiscal Adjustment
Government Expenditure Cut
VAT rise of 3%
Public Sector Wage Cuts of 20%

13. • Squeeze on Labour Costs
– Fall in Real Wages, mostly in public sector
– Real Unit Labour Costs fall of 20%
– Increased Productivity

14. • High Interest Rates

15. Internal Devaluation Assessed
Iceland Fixed Exchange Rate : NEER devaluation of 50%
• The Crisis in Latvia: deeper (20%) and V-shaped
– Iceland: 10%
• Faster and More Sustainable Recovery in Latvia: 4% annual GDP:
– Spare Capacity
– Iceland: 2%, but relating to pre-crisis size of economy
• Exports: -10%
– Iceland: +15%
• Unemployment: peak of 18%, 2013: 9.8%
– 9%. 2013: 5%
• Inflation: 9% peak followed by Stability at 2%
– Iceland: 12% (2009), continues at one of highest in Europe
• Sovereign Debt: Denominator Effect
– Increasing Debt
• Similar Current Account situation
• Competitiveness Improved
• Reassurance of Investors

16. IMF-Parex
• Restoration of healthy levels of GDP
• Unemployment down 3%
• Competitiveness:
– Macroeconomic Environment:
– Labour Efficiency: 18 ↓ to 27th
– Investors Confidence: 93rd to 29th
• Market Confidence: BBB+
• Improved Government Finances: December 2012 US$ Issue at 2.75%
• Early IMF Repayment
• Current Account Normalisation
• Fiscal Discipline Law
• National Strategic Plan
Results

17. Competitiveness
• Transition Stage:
Efficiency→ Innovation
Positive Developments:
 Index Rank:
44th (2007)
70th (2010)
52nd (2013)
 Labour Market
Competitiveness
Estonia Rank: 34th

18. Inflation Rate

19. Latest Developments

20. IMF Concluding Statement: 10/3/14
“The Outlook for 2014 is Broadly Favourable”
Praise:
• 4%: Fastest Rate of Growth in Europe
• Real Effective Exchange Rate is in line with
fundamentals
• Unemployment: 11.3%
• The Output Gap has been largely Closed
• A Balanced Recovery: C, I, X

21. Gross National Savings

22. • Short-Term Warnings : Dependency on
Performance of neighbouring economies
– Escalation of Ukrainian Crisis
– Tapering of Unconventional Monetary Policy
– Contracting Banking Credit, hampered by private
sector debt overhang
– Closure of Output Gap
• Recommendations:
– Maintain Competitiveness through Structural Reforms
– Fiscal Consolidation: Income Tax
– Reinforcement of security net
– Reduction in reliance on foreign deposits
– Resuscitate stagnant banking sector

23. Private Sector Credit

24. Bank Asset to Capital Ratio

25. Recommendations
Medium to Long-Term:
• Land Infrastructure
• Liberalisation of Energy Market
• Emphasis on Vocational and Higher Education
• Strengthening of Judicial system, especially
liabilities
• Reducing the Grey Economy
• Reconsideration of tax system to improve
inequality: Land, Consumption, Thresholds

26. Inequality
and
Innovation

27. Government Finances
Government
Debt (% GDP)
Budget Surplus 2012: -1.8%*

28. • Speculative Investment Bubble
• “Market Stability is Destabilizing”
• Stages:
– Hedge Borrower: Cash Flows<=Debt-associated payments
Example: mortgages
– Speculative Borrower: Overconfident Euphoria
Example: interest-only loan
– Ponzi Borrower: Excess Debt Accumulates
Example: Negative Amortization Loan
– Debt Exceeds Repayment Capabilities – Minsky Moment
• Stood for better understanding of finance and of
ending overreliance on mathematical models
Hyman Minsky Crisis Theory

29. Exports
• Account for 62% of
GDP
• Increased 7 times
between 2000-2012
• Exports: food, wood,
chemicals, metals,
services
• Unconventional
Importers: Russia,
Lithuania, Estonia,
Germany, Poland

30. Imports
Closer Neighbouring States

31. Industrial Production
Trade/GDP = 118%

32. Balance of Payments

33. Aggregate Demand
• AD sectors:
– Consumption (62%)
– Investment (23%)
– Government Spending
(15%)
• Crisis:
– Consumption: -32%
– Investment: -76%

34. Foreign Direct Investment
Net

35. The End
Not Quite yet

36. Key Definitions
• Purchasing Power Parity: the sum value of all
goods and services produced in a country valued
in US dollars
• Human Development Index: a composite statistic
of life expectancy, education, and income which
is used to rank countries into four tiers
of development
• High-technology exports: products with high
R&D intensity, such as in aerospace, computers,
pharmaceuticals, scientific instruments, and
electrical machinery

37. Exchange Rates
• Nominal Exchange Rate (S) – price of domestic
money in terms of foreign money
• Real Exchange Rate (𝜎) – the relative price of
our goods and services in terms of foreign
goods
𝜎 =
𝑃
𝑃∗/𝑆
• NEER: Nominal Effective Exchange Rate
• REER: Real Effective Exchange Rate

38. Exchange Rates
• Floating Exchange Rates
• Fixed Exchange Rates:
– Positive:
• Stable Trade – possibility of Union
• Limited Speculation
• High Fluctuation
– Negative:
• Cannot perfectly adjust to inflation – Misalignment
• Prone to crises
• Inability to accommodate to external shocks → Internal Devaluation
• Difficulty of Estimation
• Impossible Trilogy:
1) Fixed Exchange Rates
2) Full Capital Mobility
3) Monetary Policy Independence

39. Peg Implementation
Short-term:
• Central Bank Interventions
Long-Term:
• Interest Rates
• Currency Controls
• IMF Special Drawing Rights
Very Long-term:
• Protectionism
• Supply-side reforms
• Dirty Float

40. Currency Blocs
Advantages:
• Reduced Exchange Rate Costs
– Commissions and charges
– Risk factors of currency fluctuations
• Greater Price Transparency
– Comparison of prices
– Lower price discrimination
• Greater Business Confidence
– Stability promotes investment
• Macroeconomic Management
Disadvantages:
• Transition Costs
• Less Monetary Independence

41. Gini Coefficient
• The principle measure of
income inequality
• 𝐺𝑖𝑛𝑖 =
𝐴𝑟𝑒𝑎(𝐴)
𝐴𝑟𝑒𝑎(𝐴+𝐵)
• Gini= 0 – perfect equality
– Gini=1 – perfect inequality
• Example Values:
– South Africa: 0.63
– Sweden: 0.23
– UK: 0.40
– Latvia: 0.35

42. Balance of Payments
• Export of Goods
• Import of Goods
• Export of Services
• Import of Services
• Net Royalties
• Net Investment Income
• Net International Aid
• Gross Inward Direct Investment
• Gross Outward Direct Investment
• Gross Inward Portfolio Investment
• Gross Outward Portfolio
Investment
• Short-Term Inward Capital Flows
• Short-Term Outward Capital Flows
• Errors and Omissions
• Official Intervention Account
Trade Balance
Current Account Balance
Capital Account Balance
Current Account + Financial Account + Official Intervention=0

43. Balance of Payments
Export of Goods
Import of Goods
Export of Services
Import of Services
Net Investment Income/Royalties
Net International Aid/Transfers
Gross Inward Direct Investment
Gross Outward Direct Investment
Gross Inward Portfolio Investment
Gross Outward Portfolio Investment
Short-Term Inward Capital Flows
Short-Term Outward Capital Flows
Errors and Omissions
Official Intervention Account
Trade Balance
Current Account Balance
Capital Account Balance
Current Account + Financial Account + Official Intervention=0

44. Deficit on the Current Account:
• Excess Supply of Currency
– Depreciation of Currency
– Restoration of Equilibrium
• Exports
• Asset Attractiveness
• Net Leakage of Demand
• Loss of Jobs
• Long-term Confidence

45. Competitiveness
1) Price Competitiveness:
• Relative Unit Labour Costs – labour cost per unit
of output
2) Non-Price Competitiveness:
• Regulation:
• Environmental
• Employment
• Pensions
• Taxation

46. World Economic Forum
Global
Competitiveness Index

47. Rating Agencies

48. Internal Devaluation
• Definition: pro-cyclical measure which occurs
when a country attempts to improve
competitiveness through lowering unit wage
costs and increasing labour productivity,
rather than through currency depreciation
• Latvia had no choice but to internally devalue
due to Lat peg.

49. Maastricht Criteria
(part of the “Treaty on European Union”, 1992)
• Fifth Stage of Integration: European Economic and
Monetary Union
• Criteria:
1) Inflation: no more than 1.5% above average of Top-3
European economies
2)
𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝐷𝑒𝑓𝑖𝑐𝑖𝑡
𝐺𝐷𝑃
≤3% or converging to this value
3)
𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝐷𝑒𝑏𝑡
𝐺𝐷𝑃
≤ 60% or converging
4) Exchange Rate Mechanism Membership with two
years stable peg
5) 10yr Government Bonds yields: no more than 2%
above Top-3 European economies

50. • Surveillance Role
– Article IV: Annual Visits and Evaluations
– World Economic Outlook
– Enhanced Surveillance
– Macroeconomic Guidance
– Statistical Innovations
• Lender of Last Resort: “the International Fire-fighter”
– Duration of Loan: 1-4 years
– Highest Priority
– Types:
• Special Drawing Rights (SDR) – an allocated line of credit based on
each country’s annual contributions
• Concessional Loans
• Stand-by Arrangements
Founded: Bretton Woods (1945); 188 members; Centre: Washington DC
Directorship: Board of Governors, Board of Executive Directors

51. • SDRs are evaluated according to each country’s
annual contributions, which are themselves based on
GDP
– £1 = SDR1.08
• Votes amongst the Executive Directors are
distributed accordingly
Latvia 142 0.06%
Special Drawing Rights and Votes

52. Denominator Effect

54. NOW SERVING 50 EUROPEAN
DESTINATIONS VIA RIGA
JURMALA:
FROM GATWICK
MOSCOW:
FROM GATWICK
Jurmala
Ssa SALE RIGA:
FROM GATWICK
€85
http://www.economist.com/blogs/charlemagne/2012/06/lessons-
latvia?zid=307&ah=5e80419d1bc9821ebe173f4f0f060a07

55. List of Useful Websites
• IMF
• World Bank
• CIA World Factbook
• The New York Times
– Paul Krugman Blogs
• The Economist
– Login: library@henleycol.ac.uk
– Password: library
• BBC Business
– Robert Peston
– Linda Yueh

56. Quiz Question
Balance of Payments
Trade Balance 67.6
Balance on Goods and Services 68.1
Net Investment Income/Royalties -35.4
Aid/Transfers -45.0
Direct Investment Abroad -228.6
Direct Investment Inward 146.1
Portfolio Investment Assets -258.3
Portfolio Investment Liabilities 290.1
Capital (Financial) Account -43.2
Other Investment Assets, eg Financial Derivatives -219.2
Other Investment Liabilities 226.5
Errors and Omissions ?
Official Intervention Account (Reserves) 16.9
Answer : -38.6