Cecilia Hermansson, Chief Economist at Swedbank, delivered a speech at a conference in Riga celebrating Latvia's completion of its IMF and EU support program. In her speech, she: 1) Praised Latvia's strong economic recovery and commitment to reforms following the deep recession, while noting remaining challenges. 2) Emphasized the need to close productivity gaps, adapt to demographic changes, and strengthen institutions to sustain recovery. 3) Concluded that Latvia and other Baltic states must maintain reform momentum to avoid problems seen in Southern Europe and further improve competitiveness.

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 7740
e-mail: ek.sekr@swedbank.com Internet: www.swedbank.com 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. crisis awareness. Despite expectations of many academics and fi-
nancial analysts, the exchange rate peg has held, and Estonia has
even made it into the euro area. For Latvia, the support from IMF and
European partners has been crucial for its success, although I believe
the program would not have worked without the active involvement
and 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 11
Source: Ecowin, National Statistics.
The deep recession has brought with it great economic and social
costs, 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 we
focus on the vulnerabilities that remain and the challenges that must
be dealt with in order to sustain the recovery and continue improving
competitiveness.
As it made sense for Estonia to become a member of the euro area, it
also makes sense for Latvia and Lithuania. For these countries, which
have for a long time maintained a fixed exchange rate regime, taking
the step towards full membership means access to a larger capital
market, increased stability and participation in euro area policymak-
ing. This, I believe, outweighs the possible drawbacks of giving up
flexibility 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 7-8
years ago. The most important is to avoid reform fatigue and to focus
on structural reforms that safeguard budget discipline and high pro-
ductivity growth.
2 Swedbank Analysis No 5 • 8 June 2012

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 Lithuania
Source: Eurostat.
I will concentrate my discussion on three main challenges: 1) making
the most of globalisation and closing the productivity gap, 2) adapting
to demography and labor market trends, and 3) the need to
strengthen institutions.
Market share developments (goods exports), Index 2001 = 100
200
LT
180
160 DE
140 EE
120 SK
100 LV
80
SE
60
40 FI
Source: Eurostat.
All three Baltic countries have been successful in gaining market
share 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 and
labour 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. The
Baltic countries are at a cross roads, and should avoid competing
with low-cost production, and instead strive to move up the value-
added chain.
Swedbank Analysis No 5 • 8 June 2012
3

4. It is therefore important to close the productivity gap, which is some
50 % 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 and
gross expenditures in R & D and patents rank almost last out of the
27 EU countries.
The same applies to competitiveness, as measured by the World
Economic Forum. While Latvia ranks 70th out of 139 countries, only
Greece and Bulgaria rank lower within the European Union. The
situation is somewhat better when analysing trade and external
openness, and especially when taking note of the World Bank’s “ease
of doing business” survey, where all three countries rank high in sup-
porting flexibility and the entrepreneurial spirit.
Closing the Productivity Gap Estonia Latvia Lithuania
Value Added in Manufacturing, % av EU27 (2010) 67 45 73
Gross Domestic Expenditures on R & D, ranking of EU27 (2010) 14 24 20
Patents, ranking of EU27 (2009) 16 23 26
Competitiveness (WEF), ranking of 139 countries (2011/2012) 33 70 47
Competitiveness (WEF), of EU27 (2011/2012) 12 25 19
Enabling Trade (WEF), ranking of 132 countries (2012) 26 52 45
Ease of Doing Business (WB), ranking of 183 countries (2012) 24 21 27
Source: Eurostat, World Economic Forum (WEF), World Bank (WB)
Going forward, a faster increase in real wages than in productivity
needs to be avoided. What is making the situation more difficult,
however, is the adverse demographic situation, which is driven by low
fertility, aging, and the combination of heavy emigration and light im-
migration.
Population forecasts show a steep decline, with an added burden on
the young and the social welfare system. The declining population is
reducing the labour force and, in turn, lowering savings. A decreasing
number of economically active people is tightening the labour market,
which can lead to rising wages. The changing size and structure of
the population can also weaken demand, especially in such sectors
as housing and infrastructure.
4 Swedbank Analysis No 5 • 8 June 2012

5. Population forecast to 2050
4,0
Lithuania
3,5
3,0
Person (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 economic
growth. In addition, an older labour force is less geographically and
occupationally 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 dynamic
society, as new people also bring new ideas. Also, supporting men
and women balancing work life and family life is important.
Swedbank Analysis No 5 • 8 June 2012
5

6. Despite high unemployment, companies are finding it difficult to find
competent labour in certain sectors. It is important to strengthen the
driving force to participate on the labour market. It is also important to
match educational attainment to labour market needs – to do this, it
will be necessary to close the gap between academia and the busi-
ness community, which is large. And, while education performance is
generally 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 EcoWin
Source: Ecowin, National Statistics.
One of the main factors for success in countries’ performance seems
to be the strength of institutions, creating confidence and making it
easier for households, investors, and business actors to predict the
future. Latvian companies, in answering the World Economic Forum
questionnaire on the most problematic factors for doing business,
mention tax regulations, inefficient government bureaucracy, and low
access 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 legal
framework, and the large extent and effect of taxation are factors
ranking among the lowest in the world of some 110-120 out of 139
countries. 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. 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
90
Source: 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 restrictive
lending policies. A normalisation will come, as is starting to be visible
in Estonia, but the situation is still fragile, not least due to the crisis in
the euro area. For start-ups, there is a need to build new institutions
with cooperation between the banking sector and the government
stimulating 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 financial
sector.
A crisis is a terrible thing to waste! I believe the Baltic countries have
not wasted this crisis, but with the challenges remaining, the speed of
reform must be kept up, and the mistakes of Greece and Portugal
must not be repeated. A fixed exchange rate means focusing more on
budget discipline and competitiveness, and not least maintaining the
speed and ambitions of structural reforms.
Thank you!
Swedbank Analysis No 5 • 8 June 2012
7

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Cecilia Hermansson,
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+46-8-5859 7720.
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ISSN 1103-4897