Extract 3 imf praise for Latvia

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Extract 3 imf praise for Latvia

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Extract 3 imf praise for Latvia

  1. 1. Extract  3:  IMF  praise  for  fiscal  austerity  in  Latvia     Latvia  is  one  of  the  featured  countries  in  the  June  2014  Case  Study.    Click  here  for  BBC   Country  Profile   • Latvia  is  one  of  the  Baltic  States  –  the  others  are  Estonia  and  Lithuania   • It  is  a  small  country  with  a  total  population  of  just  over  two  million  people.     • Globally  it  procures  only  0.05%  of  world  output  of  goods  and  services   • It  is  also  small  in  a  European  Union  context  but  Latvia  is  a  highly  open  economy   with  trade  accounting  for  a  large  share  of  GDP   • All  three  Baltic  States  countries  joined  the  European  Union  in  May  2004  as  part   of  the  largest  enlargement  that  the  EU  single  market  has  ever  seen   • On  1st  of  January  2014,  Latvia  joined  the  single  European  currency  –  the  18th   country  to  join   Selection  of  basic  statistics  on  the  Latvian  economy     (Sources:  OECD  World  Economic  Outlook,  World  Economic  Forum,  BBC,  IMF  and  World   Trade  Organisation)   • Population  (thousands,  2012):  2,025  –  there  is  a  large  Russian  ethnic  minority   • The  Latvia  population  is  declining  -­‐  Between  2000  and  2011;  the  population  fell   by  about  13%.     • GDP  (million  current  US$,  2012):  $28,324     • GDP  (million  current  PPP  US$,  2012):  $42,471       • Current  account  balance  (million  US$,  2012):  -­‐$473m         • Trade  to  GDP  ratio  (2010-­‐2012):  117.8%   • GDP  (PPP)  as  share  (%)  of  world  total:  0.05   • National  minimum  wage  for  Latvia:  200  lats  (£237;  284  Euros;  $392)  per  month   Breakdown  of  total  Latvian  exports  (2012)   1. European  Union  (27):  68.8     2. Russian  Federation:  11.4   3. Norway:  2.6     4. Algeria:  2.1       5. Belarus:  1.8     Breakdown  of  total  Latvian  imports  (2012)   1. European  Union  (27):  77.3   2. Russian  Federation:  9.4   3. Belarus:  3.6   4. China:  2.8   5. Ukraine:  1.4    
  2. 2. International  competitiveness  ranking   • Global  Competitiveness  Index  (2013):  52  out  of  148  countries   • Latvia  scored  highly  for  ease  of  doing  business  =  the  government  has  followed   pro-­‐private  sector  policies  in  recent  years   Focus  on  Latvia’s  Exchange  Rate  and  Balance  of  Payments     Extract   In  December  2008  the  IMF  announced  plans  to  lend  €1.7  billion  to  Latvia  to  help  to   stabilise  its  economy.     This  financial  assistance  was  supplemented  by  loans  from  the  European  Union  (EU),   the  World  Bank  and  several  Nordic  countries  to  provide  a  package  totalling  €7.5   billion.     The  assistance  was  part  of  an  agreement  to  defend  Latvia’s  currency  peg  to  the  euro   (a  fixed  exchange  rate)  and  the  country’s  commitment  to  join  the  euro.     The  Latvian  currency,  the  lat,  had  come  under  pressure  as  a  result  of  a  current   account  deficit  on  the  balance  of  payments  of  almost  25%  of  GDP  in  2007.     This  deficit  was  financed  by  increasing  levels  of  private  sector  external  debt.     The  credit  and  growth  boom  that  followed  Latvia’s  accession  to  the  EU  simply  could   not  be  sustained.     Very  high  wage  growth,  far  in  excess  of  productivity  growth,  had  severely   undermined  Latvia’s  international  competitiveness  and  contributed  to  the   economy’s  large  external  imbalances.     Latvia  was  once  the  fastest  growing  economy  in  the  EU.  By  the  end  of  2008  it  was  the   worst-­‐performing  economy.   What  is  meant  by  a  currency  peg  to  the  Euro?   • A  currency  peg  is  an  announced  fixed  exchange  rate,  normally  against  a  major   currency  like  the  Euro  or  the  US  dollar,  but  also  sometimes  against  a  basket  of   currencies.   •  From  January  2005  onwards  the  Latvian  lat  was  pegged  at  1.43  lats  to  the  euro.     • The  lat  was  left  to  float  against  the  US  dollar  prior  to  Latvia  joining  the  Euro  in   January  2014.   • A  currency  peg  is  maintained  through  intervention  in  the  currency  markets  by   a  central  bank.   How  can  a  central  bank  maintain  a  currency  peg?   If  a  currency  is  under  strong  selling  pressure,  then  the  central  bank  might  decide  to:  
  3. 3. 1. Raise  domestic  policy  interest  rates:  Increasing  interest  rates  will  lift  the   expected  return  to  short  term  flows  of  capital  coming  into  the  country’s  banking   system.  Other  things  being  equal,  an  influx  of  “hot  money”  will  cause  an   outward  shift  in  demand  for  the  currency  and  an  appreciation  of  the  exchange   rate  –  helping  to  maintain  the  currency  peg.   2. Direct  intervention:  The  central  may  also  go  into  the  currency  market  and   intervene  directly  by  buying  up  their  own  currency  (e.g.  the  Latvian  lat)  and   selling  others  (e.g.  the  Euro).  This  is  why  countries  that  want  to  stabilise  the   external  value  of  their  currency  often  have  to  maintain  quite  high  reserves  of   foreign  currencies  so  that  intervention  –  if  and  when  it  happens  –  can  be   effective.   3. Legal  controls:  Another  option  –  but  one  rarely  used  –  is  for  a  government  to   declare  a  fixed  exchange  rate  and  make  it  illegal  for  foreign  trade  in  goods  and   services  to  take  place  at  any  other  announced  exchange  rate.  The  main  difficulty   with  this  is  that  is  naturally  encourages  black  markets  to  emerge  with  unofficial   exchange  rates  for  many  transactions.   As  part  of  their  currency  peg  against  the  Euro,  the  Latvian  central  bank  held  foreign   exchange  reserves  to  back  every  lats  in  circulation  –  so  that  there  was  a  sufficient   buffer  stock.  The  end  result  was  a  strong  surge  in  Latvia’s  foreign  exchange  reserves.   The  value  of  the  Latvia  currency  against  the  Euro  is  shown  in  our  next  chart  below.     Daily exchange rate for the Lat against the Euro Latvian Currency v The Euro Source: International Monetary Fund 02 03 04 05 06 07 08 09 10 11 12 13 14 0.550 0.575 0.600 0.625 0.650 0.675 0.700 0.725 EUR/LVL 0.550 0.575 0.600 0.625 0.650 0.675 0.700 0.725
  4. 4. • The  currency  peg  system  against  the  Euro  was  in  place  for  nine  years  from   January  2005  through  to  Latvian  accession  to  the  Euro  in  January  2014.  In   January  2009  for  example,  1  EUR  =  0.702804  LVL  i.e.  one  lat  was  worth  around   Euro  1.42   • Basically  the  lats  was  a  fixed  exchange  rate  against  the  Euro  over  this  period  –   the  currency  peg  was  maintained,  although  when  the  global  financial  crisis   engulfed  Latvia  and  many  other  countries,  there  was  strong  pressure  on  the   country  to  end  their  peg  and  allow  a  devaluation  of  the  Lats  by  perhaps  25%  or   more.     • A  key  point  to  remember  is  that,  although  the  lats/euro  exchange  rate  was  fixed,   the  euro  itself  was  floating  in  global  currency  markets.  So  that  any  fall  in  the   Euro  against  the  US  dollar  or  the  British  pound  for  example  would  bring  about  a   similar  depreciation  of  the  lats.      
  5. 5. Analyse  how  a  current  account  deficit  can  put  the  external  value  of  a  currency   under  pressure   A  current  account  deficit  happens  when  a  country  is  running  a  net  deficit  in  trade  in   goods  and  services,  net  investment  income  and  net  transfers.  It  represents  a  net   outflow  from  the  circular  flow  of  income  and  spending,  and  a  net  outflow  of   currency  from  the  deficit  country.  This  deficit  can  be  shown  by  an  outward  shift  in   currency  supply  which  –  other  factors  remaining  equal  –  will  put  downward  pressure   on  a  nation’s  currency  value.     Be  able  to  use  a  currency  supply  and  demand  diagram  to  show  this  if  asked  in  the   exam   The  scale  of  Latvia’s  current  account  deficits  in  the  middle  part  of  the  last  decade  was   staggering.    Any  country  running  an  external  deficit  of  more  than  10%  of  GDP  is  often   running  into  trouble,  but  Latvia’s  balance  of  payments  gap  on  the  current  account  far   exceeded  even  this!  The  figures  were  as  follows:   • 2005:  -­‐12.9%  of  GDP   • 2006:  -­‐12.5%  of  GDP   • 2007:  -­‐22.5%  of  GDP   • 2008:  -­‐22.3%  of  GDP   • 2009:  -­‐13.1%  of  GDP   • 2010:  +8.6%  of  GDP   Note  here  the  dramatic  turnaround  in  Latvia’s  current  account  between  2009  and  2010   How  is  a  current  account  deficit  financed?   • A  current  account  deficit  essentially  represents  a  negative  balance  of  trade,   investment  income  and  transfers  between  once  country  and  the  rest  of  the   world.     • The  current  account  of  the  Balance  of  Payments  can  also  be  expressed  as  the   difference  between  national  (both  public  and  private)  savings  and   investment.  A  current  account  deficit  may  therefore  reflect  a  low  level  of   national  savings  relative  to  investment  or  a  high  rate  of  investment—or  both.  In   Latvia’s  case  the  current  account  deficit  was  the  direct  consequences  of  an   unsustainable  borrowing  boom  much  of  which  was  met  by  a  surge  in  imports.   • A  current  account  deficit  is  financed  by  the  deficit  country  attracting  foreign   capital.  It  needs  to  attract  a  large  net  inflow  of  capital  from  overseas  in  order  to   balance  the  accounts  as  a  whole.   Where  does  this  foreign  capital  come  from?     There  are  plenty  of  alternatives  but  much  will  depend  on  the  economy  itself  –  including   the  stage  of  development,  the  attractiveness  of  an  economy  to  inward  investment  and   the  strength  and  stability  of  institutions  such  as  banks,  bond  markets  and  stock  markets.   Foreign  capital  might  come  in  from:  
  6. 6. 1. Inflows  of  portfolio  investment  into  equities  (shares),  property  and  bonds   2. Short  term  inflows  of  “hot  money”  into  a  country’s  banking  system  perhaps   attracted  by  relatively  high  interest  rates  available  on  savings  deposits   3. Foreign  direct  investment  projects  such  as  transnational  businesses  launching   capital  investment  projects  or  through  takeover  activity   What  caused  the  credit  and  growth  boom  in  Latvia  after  her  entry  into  the  EU  in   2004?   The  boom  was  in  large  part  the  result  of  Latvia  joining  the  European  Union  in  May  2004.   The  decision  to  go  ahead  with  EU  enlargement  had  been  made  a  few  years  earlier  and   one  effect  of  this  was  a  pre-­‐accession  and  post-­‐accession  boom  in  inward  investment.   Businesses  believed  in  and  saw  opportunities  from  incomes  per  capita  in  Latvia  and   other  Baltic  States  converging  closer  to  average  EU  per  capita  incomes   The  boom  was  also  fuelled  by  lower  interest  rates  on  offer  to  consumers  and  businesses   from  foreign-­‐owned  banks,  and  a  sharp  rise  in  expectations  or  Keynesian  animal  spirits.   Lower  interest  rates  brought  about  a  surge  in  house  prices  and  in  spending  on   consumer  durables.  Consider  the  chart  below  which  tracks  purchases  of  new  cars  in   Latvia.  Keep  in  mind  that  Latvia  does  not  produce  any  cars  of  its  own!     Outline  some  of  the  consequences  of  a  credit  and  growth  boom  such  as  that   experienced  by  Latvia   Latvia, New Passenger Car Registrations Source: Reuters EcoWin 04 05 06 07 08 09 10 11 12 13 0 500 1000 1500 2000 2500 3000 3500 Numberofnewcarsregisteredpermonth 0 500 1000 1500 2000 2500 3000 3500
  7. 7. In  the  short  term,  the  boom  in  real  GDP  growth  fuelled  by  a  money  and  credit  surge   produced  some  positive  effects  for  Latvia.  Unemployment  fell  and  real  living  standards   increased.  But,  like  many  booms  in  other  countries,  this  was  unbalanced  expansion  built   on  the  flimsy  foundations  of  an  asset  price  bubble.   The  consequences  included:   1. Inflation:  A  sharp  increase  in  consumer  prices  inflation  and  a  worsening  of   international  competitiveness.  Remember  that  Latvia  was  operating  a  fixed   currency  peg  against  the  Euro,  so  if  their  inflation  rate  was  higher  than  EU   countries,  the  relative  prices  of  Latvian  products  becomes  more  expensive   2. Bursting  of  the  credit  bubble  and  deep  recession:  The  unsustainable  bubble   in  credit  came  up  against  the  start  of  the  global  financial  crisis  best  described  as   a  sudden  credit  crunch.  Banks  stopped  lending  the  global  slowdown  caused  a   steep  decline  in  exports  from  Latvia.  And  the  economy  fast  descended  into  a   deep  recession  made  worse  by  billions  of  euro  of  bad  debts  in  the  Latvian   banking  system.       The  components  of  the  current  account  for  Latvia  are  shown  in  the  next  chart.     • By  far  the  biggest  cause  of  the  current  account  deficit  was  the  huge  trade  deficit   in  goods.  It  reached  a  monthly  peak  of  nearly  400  million  lats  in  the  summer  of   2007.     • Net  investment  income  for  Latvia  is  negative,  balanced  out  by  net  inflows  of   transfer  payments.  As  one  of  Europe’s  relatively  poorer  countries,  Latvia  is  in   receipt  of  structural  funding  from  the  EU  budget.  And  sizeable  net  outward   migration  from  Latvia  has  meant  that  the  country  also  receives  a  flow  of   remittance  income  from  Latvians  living  and  working  overseas.     • The  country  runs  a  small  but  growing  surplus  in  trade  in  services   • Tourism  is  becoming  an  increasingly  important  source  of  growth  and  foreign   exchange  for  the  country.  
  8. 8.       Monthly net balances for trade in goods, services, transfers and investment income Latvia - Balance of Payments - Current Account Goods Services Income Current Transfers Source: Reuters EcoWin 05 06 07 08 09 10 11 12 13 millions -400 -300 -200 -100 0 100 200 300 LatvianLats(millions) -400 -300 -200 -100 0 100 200 300
  9. 9. Focus  on  Competitiveness   Why  does  fast  wage  growth  in  excess  of  productivity  growth  cause  a  fall  in   competitiveness?   The  key  to  this  question  is  to  understand  that  the  basic  measure  of  competitiveness  is  an   index  of  relative  unit  labour  costs  (RULCs).  This  measures  the  labour  cost  per  unit  of   output  and  is  determined  by  two  key  factors  –  namely  the  rate  of  growth  of  wages  and   the  rate  of  growth  of  labour  productivity  (I.e.  output  per  person  employed  or  output   per  person  hour).   Consider  two  simple  numerical  examples:   • If  wages  are  rising  at  6%  per  year  and  labour  productivity  is  growing  by  3%  per   year,  then  unit  labour  costs  will  be  rising  by  3%.   • If  wages  are  rising  at  4%  per  year  and  labour  productivity  is  growing  by  5%  per   year,  then  unit  labour  costs  will  be  falling  by  1%.   A  country  whose  unit  labour  costs  are  increasing  at  a  rapid  rate  risks  losing  price  and   competitiveness  from  year  to  year.  Businesses  who  find  that  their  supply  costs  are  rising   will  be  under  pressure  to  raise  prices  to  protect  their  profit  margins  and  this  can  lead  to   consumers  in  domestic  and  overseas  markets.  Exporters  for  example  may  find  that  they   start  losing  market  share  to  suppliers  in  other  countries  whose  costs  are  not  growing  as   quickly.   The  term  relative  unit  labour  costs  mean  that  we  must  also  consider  what  is  happening   to  unit  labour  costs  in  other  countries.  For  example,  if  unit  labour  costs  are  rising  by   5%in  Latvia  and  only  2%  in  other  EU  countries,  then  Latvia  will  suffer  a  worsening  of   international  competitiveness.     What  is  meant  by  international  competitiveness  and  how  is  it  measured?   International  (or  external  competitiveness)  is  the  ability  to  sell  goods  and  services  at   competitive  prices  in  a  foreign  country.   There  are  two  main  types  of  competitiveness   1. Cost  (price)  competitiveness  –  differences  in  unit  costs  between  producers  –     eventually  reflected  in  the  market  prices  for  goods  and  services   2. Non-­‐price  competitiveness  –  this  encompasses  technical  factors  such  as   product  quality,  design,  reliability  and  performance,  choice,  after-­‐sales  services,   marketing,  branding  and  the  availability  and  cost  of  replacement  parts   When  assessing  competitiveness,  non  cost  factors  include:   • Costs  of  meeting  environmental  /  health  regulations   • Environmental  taxes  e.g.  carbon  taxes  and  waste  taxes   • Employment  protection  laws  and  health  and  safety  laws   • Requirements  to  provide  pensions  for  employees  
  10. 10. Each  year  the  World  Economic  Forum  publishes  a  detailed  survey  and  ranking  of   countries  in  terms  of  their  overall  competitiveness.  We  will  look  at  this  when  considered   the  competitive  positions  of  Latvia  and  Iceland  later  on  in  this  case  study  toolkit.    

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