Extract 4 internal v external devaluation


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Extract 4 internal v external devaluation

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Extract 4 internal v external devaluation

  1. 1. Extract  4:  Latvia  and  Iceland  –  Internal  Devaluation  v  Exchange  Rate   Devaluation     Extract     Some  economists  are  sceptical  about  the  success  of  Latvia’s  internal  devaluation  in   delivering  a  sustained  economic  recovery  and  correcting  external  imbalances.   Although  Latvia’s  GDP  has  grown  since  2010,  it  is  not  clear  that  such  growth  can  be   sustained.  This  is  because  of  the  sharp  change  in  the  composition  of  GDP  growth   which  has  resulted  from  internal  devaluation.     High  levels  of  private  sector  indebtedness  remain  in  Latvia  and,  as  a  result,  growth  in   both  investment  and  consumer  expenditure  remain  weak  (see  Fig.  4.1).  Fiscal   tightening  has  limited  the  contribution  of  government  expenditure  to  GDP  growth.   Latvia’s  economic  growth  is,  therefore,  very  heavily  dependent  on  growth  in  net   trade.     Whether  Latvia  can  sustain  economic  growth  solely  from  exports  depends  not  only  on   the  growth  in  world  trade  but  also  on  Latvia’s  international  competitiveness.   What  is  meant  by  an  internal  devaluation?   An  internal  devaluation  happens  where  the  government  of  a  country  attempts  to   improve  competitiveness  (and  ultimately  the  trade  balance)  through  lowering  unit   wage  costs  and  increasing  labour  productivity  rather  than  relying  on  a  depreciation   or  devaluation  of  their  exchange  rate.   How  did  Latvia  achieve  an  internal  devaluation?   This  was  attempted  using  a  mix  of  macroeconomic  policies:   1. Maintaining  Latvia’s  fixed  exchange  rate  against  the  Euro  –  i.e.  avoiding  a   depreciation  which  is  usually  regarded  as  a  counter-­‐cyclical,  expansionary  policy   –  one  reason  for  this  was  that  the  vast  bulk  of  her  debts  are  in  euros  –  this  is  a   big  risk  if  the  exchange  rate  collapses   2. Implementing  pro-­‐cyclical  fiscal  policies  such  as  higher  taxes  and  cuts  in   government  spending  –  that  made  the  downturn  worse  in  the  short  run  with   the  aim  of  cutting  their  budget  deficit.  In  Latvia,  VAT  was  raised  by  3%  and   wages  &  salaries  in  the  public  sector  were  cut  by  more  than  20%.   3. Rising  real  interest  rates  –  official  monetary  policy  interest  rates  in  Latvia   remained  at  7.5%  throughout  the  recession  and  with  inflation  falling  and  briefly   entering  deflation  in  2009-­‐2010,  the  real  cost  of  borrowed  money  was   positive.  At  the  start  of  2010,  with  nominal  interest  rates  at  7.5%  and  CPI   inflation  at  -­‐4%,  the  real  interest  rate  was  approximately  +11.5%  -­‐  strongly   deflationary  for  the  Latvian  economy.  
  2. 2. Key  point:  Latvia  chose  a  strategy  of  internal  devaluation  in  the  wake  of  the  start  of  the   global  financial  crisis  –  the  bulk  of  their  macro  policies  were  pro-­‐cyclical  rather  than   the  Keynesian  approach  of  introducing  counter-­‐cyclical  policies  to  address  falling   output  and  employment.   Crucial  issues  to  address  in  the  case  study  include  whether  Latvia’s  strategy  has  worked   and  whether  the  economic  and  social  (human)  costs  have  been  worth  it.  Has  Iceland’s   devaluation  been  a  better  option?     Per cent Latvia: CPI Inflation and Policy Interest Rates CPI Inflation for Latvia (%) Policy Interest Rates for Latvia (%) Source: Euro Stat Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep 07 08 09 10 11 12 13 -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0
  3. 3. Fig.  4.1  –  Latvian  investment  and  consumer  expenditure  (billion  lats,   constant  2000  prices)     Analysis  of  the  data  chart  in  Figure  4.1   Note  the  way  in  which  the  data  is  presented:   • The  data  is  quarterly  i.e.  four  data  points  each  year   • It  is  measured  in  lats  –  the  Latvian  currency  until  they  joined  the  Euro  in  January   2014   • It  is  measured  at  constant  2000  prices,  i.e.  2000  is  the  base  year  and  the  figures   are  therefore  inflation-­‐adjusted,  i.e.  real  consumption  and  investment   The  peak  data  for  both  consumption  (C)  and  investment  (I)  was  in  the  final  quarter  of   2007   Thereafter,  both  C  and  I  dropped  sharply  through  2008  and  2009   In  the  1st  quarter  of  2010:   • Real  consumer  spending  was  1.1  billion  lats  compared  to  1.62  billion  lats  in  Q4   2007  –  a  fall  of  32%   • Real  investment  spending  was  0.21  billion  lats  compared  to  0.89  billion  lats  in   Q4  2007  –  down  76%   • The  percentage  fall  in  real  capital  investment  spending  was  more  than  twice  the   decline  in  real  consumer  demand  –  but  both  fell  sharply  and  by  more  than   Latvian  real  GDP  
  4. 4. Since  the  start  of  2010,  there  has  been  a  slow  recovery  in  both  consumer  demand  and   investment,  but  both  remain  well  below  the  peak  levels  of  the  4th  quarter  of  2007.   • Consumption  in  the  2nd  quarter  of  2012  was  1.28  billion  lats  –  20%  below  the   2007  peak   • Investment  in  the  2nd  quarter  of  2012  was  0.44  billion  lats  –  less  than  50%  of  the   2007  peak   Some  key  points  to  consider:   1. To  what  extent  was  the  dramatic  fall  in  consumer  spending  the  direct  result  of   the  policy  of  internal  devaluation?   2. Analyse  why  the  drop  in  consumer  demand  will  have  affected  the  real  level  of   capital  investment   3. Why  has  investment  spending  failed  to  recover  despite  a  strong  rebound  in   Latvian  economic  growth?   Extract   Internal  devaluation  puts  downward  pressure  on  nominal  wages  and  prices  and  has   been  responsible  for  restoring  some  of  Latvia’s  international  competitiveness  which   was  lost  prior  to  2007.     However,  most  of  the  reduction  in  nominal  wages  occurred  in  the  public  sector  and  not   in  the  private  sector.  In  addition,  for  reductions  in  unit  labour  costs  to  be  sustained,   there  needs  to  be  improvements  in  productivity  as  well  as  a  reduction  in  nominal   wages.     The  improvement  in  Latvia’s  current  account  balance  has  been  short  lived.  The   surplus  recorded  in  2010  disappeared  and  by  2012  a  deficit  on  the  current  account   re-­‐emerged.   What  are  nominal  wages  and  prices?   Nominal  wages  and  prices  are  the  value  of  wages  expressed  at  current  prices  i.e.  not   inflation  adjusted   To  what  extent  has  Latvia’s  international  competitiveness  improved?   We  covered  competitiveness  in  an  earlier  section  of  the  case  study  toolkit.  The  main   annual  ranking  of  global  competitiveness  comes  from  the  annual  publication  of  the   World  Economic  Forum.   In  the  2014  Global  Competitiveness  Report,  Latvia  is  ranked  52nd  out  of  148  countries,   compared  with  55th  place  in  2012-­‐2013.       A  selection  of  results  from  the  last  two  surveys  is  shown  below:  Latvia  is  well  ahead  of   Greece  (the  lowest  ranking  EU  member  country)  but  behind  fellow  Baltic  States   Estonia  and  Lithuania  and  also  Iceland.  
  5. 5. Switzerland 1 1 Singapore 2 2 Finland 3 3 Germany 4 6 United States 5 7 Sweden 6 4 United Kingdom 10 8 Norway 11 15 Korea, Rep. 25 19 Ireland 28 27 China 29 29 Iceland 31 30 Estonia 32 34 Spain 35 36 Poland 42 41 Lithuania 48 45 Portugal 51 49 Latvia 52 55 South Africa 53 52 Brazil 56 48 India 60 59 Russian Federation 64 67 Greece 91 96   Latvia  is  surrounded  by  countries  such  as  Norway,  Russia  and  Poland  –  all  of  whom   have  retained  their  own  currencies  and  seemed  to  weather  the  global  financial  crisis   relatively  well  –  Poland’s  currency  the  zloty  depreciated  by  more  than  20%  for  example.     It  was  the  only  EU  country  to  avoid  recession  after  the  2007-­‐08  financial  crises.      
  6. 6. Comparing  Latvia  and  Iceland     Extract   Economists  who  are  sceptical  about  the  success  of  Latvia’s  internal  devaluation  in   delivering  a  sustained  economic  recovery  and  correcting  external  imbalances  draw  a   comparison  with  the  experience  of  Iceland.     Unlike  Latvia,  Iceland  has  a  floating  exchange  rate.  Iceland’s  nominal  effective   exchange  rate  (NEER)  index  depreciated  by  almost  50%  after  the  end  of  2007.     In  comparison,  Latvia’s  NEER  was  broadly  unchanged  (see  Fig.  4.2).  Latvia  was  more   dependent  on  a  change  in  its  real  effective  exchange  rate  (REER),  which  depreciated   by  around  20%  measured  in  terms  of  unit  labour  costs.  This  compares  to  45%   depreciation  in  Iceland’s  REER  based  on  changes  in  unit  labour  costs.     In  addition,  Iceland’s  fiscal  tightening  was  not  as  aggressive  as  Latvia’s.  Fig.  4.3  shows   the  different  outcomes  from  2007  until  2012  in  the  two  economies  of  the  different   approaches  to  the  problem  of  external  imbalances.   This  section  makes  reference  to  “Economists  who  are  sceptical  about  the  success  of   Latvia’s  internal  devaluation”   Most  prominent  amongst  them  has  been  the  Nobel-­‐prize  winning  economist  Paul   Krugman.  In  March  2012  Krugman  wrote  a  piece  in  the  Financial  Times  entitled   “Iceland:  Recovery  and  Reconciliation.”  Krugman  argued  that:   • Iceland  “offers  a  test  of  the  advantages  of  indebted  nations  simply  letting  their   banks  collapse  and  default  on  their  loans”   • The  country  provides  a  useful  example  of  how  a  country  can  recover  from   allowing  their  currency  to  depreciate   Krugman  has  been  an  especially  vocal  critic  of  the  Latvian  model  of  internal  devaluation.   As  a  Keynesian  economist  you  would  expect  Krugman  to  believe  that  macro-­‐economic   adjustments  after  a  big  external  demand  shock  /  recession  are  easier  to  make  when  you   have  a  floating  currency  and  avoid  sticking  to  deep  fiscal  austerity  measures.     Some  Krugman  articles  to  read  on  Iceland  and  Latvia   • Latvian  adventures  (2013)  -­‐   http://krugman.blogs.nytimes.com/2013/09/19/latvian-­‐adventures/     • Baltic  Brouhaha  (2013)  -­‐   http://krugman.blogs.nytimes.com/2013/05/01/baltic-­‐brouhaha/     In  March  2013,  the  Latvian  prime  Minister  hit  back  at  Krugman:  Krugman  Can't  Admit   He  Was  Wrong  on  Austerity:  Latvia  PM:     We  also  recommend  that  you  read  this  article  from  the  Economist  (July  2012):   The  Iceland  Question:   http://www.economist.com/blogs/freeexchange/2012/07/crisis-­‐and-­‐recovery    
  7. 7.      
  8. 8. Fig.  4.2  –  Nominal  Effective  Exchange  Rate  Indices  for  Iceland  and  Latvia,   2007–11     Note  the  way  in  which  the  data  is  presented:   • The  data  shows  the  monthly  value  of  the  nominal  effective  exchange  rate  index   (NEER)   • The  base  value  for  the  index  is  December  2007,  the  base  value  is  always  100   For  Latvia,  the  nominal  exchange  rate  index  moved  within  a  narrow  band  throughout   the  period  shown  –  it  stayed  within  5%  of  the  base  year  value.  This  is  of  course  due  to   the  fixed  currency  peg  with  the  Euro.  The  nominal  exchange  rate  rose  by  around  5%   during  2009  –  which  was  a  year  of  deep  recession  for  the  Latvian  economy   For  Iceland  -­‐  operating  a  floating  exchange  rate  -­‐  depreciation  started  in  the  second   half  of  2007  but  continued  throughout  2008.  By  the  end  of  2008,  Iceland’s  nominal   exchange  rate  was  almost  50%  lower  than  a  year  earlier.  It  appreciated  in  the  early   months  of  2009  (signs  perhaps  of  some  speculative  buying  for  foreign  currency  traders)   before  falling  back  again.   Crucially  Iceland’s  nominal  exchange  rate  has  traded  at  a  discount  of  more  than  40%  to   the  December  2007  level  throughout  2009-­‐2011.  Our  updated  chart  below  carries  this   data  through  to  the  end  of  2013.   Key  question  to  consider   When  a  new  country  joins  the  EU,   it  is  expected  to  treat  its  exchange   rate  as  a  matter  of  common   interest  to  all  members  of  the  EU.   This  means  that  it  should  not   pursue  competitive   devaluations  for  fear  of   undermining  the  EU’s  single  
  9. 9. Has  a  floating  exchange  rate  and  the  significant  depreciation  of  her  currency  helped  the   Icelandic  economy  to  achieve  a  stronger,  more  sustainable  recovery  than  in  Latvia?  This   is  a  crucial  debate  in  the  June  2014  pre-­‐release  case  study  materials!     Fig.  4.3  –  A  comparison  of  key  economic  indicators  in  Iceland  and  Latvia,   2007–12     Monthly effective exchange rate index, December 2007 = 100 Iceland - Exchange Rate Index Source: International Monetary Fund 06 07 08 09 10 11 12 13 40 50 60 70 80 90 100 110 Index 40 50 60 70 80 90 100 110 A  key  reason  behind  the  dramatic  collapse  of  the   Icelandic  exchange  rate  was  that  as  the  global   financial  crisis  engulfed  the  country  they  allowed   their  three  largest  banks  –  Kaupthing,   Landsbanki  and  Glitnir,  which  together  had   assets  10  times  the  size  of  the  country’s  economy   –  to  fail.  Iceland  forced  losses  on  to  the  bank’s   creditors  leading  to  big  losses  for  foreign   investors  many  of  whom  pulled  money  out  of  the   country  
  10. 10. Note  the  way  in  which  the  data  is  presented:   • The  chart  shows  the  annual  level  of  real  national  output  (GDP)  for  Iceland  and   Latvia   • The  base  index  is  real  GDP  in  2007   • Real  GDP  for  Iceland  was  higher  in  2008  than  2007  (by  around  1%)  but  for   Latvia  there  was  a  fall  of  over  3%  during  2008   • The  deepest  year  of  recession  came  in  2009:   o Real  GDP  in  Iceland  fell  by  6.6%   o Real  GDP  in  Latvia  fell  by  18%  in  2009  (the  deepest  recession  of  any   country  in  the  world)   • In  2010   o Iceland  continued  to  experience  recession  with  another  4.1%  decline  in   real  GDP   o Latvia’s  negative  growth  rate  was  only  0.5%   • In  2011-­‐12  both  economies  started  to  recover   o  Iceland  grew  by  2.7%  in  2011  and  1.4%  in  2012   o Latvia  grew  at  a  faster  rate  but  by  the  end  of  2012,  the  economy  was  still   12%  below  the  2007  level  whereas  Iceland’s  real  GDP  was  only  4%   below  their  2007  level   Key  Questions  to  consider:   To  what  extent  was  the  shallower  recession  in  Iceland  compared  to  Latvia  in  part  the   result  of  50%  depreciation  in  her  nominal  exchange  rate  index?   To  what  extent  was  the  stronger  rate  of  growth  of  Latvian  real  GDP  a  consequence  of  her   policy  of  internal  devaluation?   What  are  some  of  the  possible  short  term  and  longer  term  consequences  for  Latvia  of   the  collapse  in  real  national  output?     Comparing  export  volumes  
  11. 11.   Note  the  way  in  which  the  data  is  presented:   • The  data  is  presented  in  index  number  format  with  a  base  year  of  2007   • The  data  shows  the  annual  level  of  export  volumes   • This  shows  the  real  quantity  of  exports  of  goods  and  services  sold  overseas   Exports  from  Latvia  fell  sharply  during  the  deep  recession  year  of  2009  –  from  an  index   of  102  to  87,  a  fall  of  just  under  15%.  Since  then  exports  have  recovered  strongly  in  each   year,  the  index  climbed  from  87  in  2009  to  110  in  2011  (an  increase  of  26%  over  two   years).  The  rate  of  increase  slowed  down  in  2012  –  this  links  to  mention  in  an  earlier   part  of  extract  4  about  whether  the  improvement  in  Latvia’s  current  account  position   can  be  maintained  given  her  dependence  on  trade.   Exports  from  Iceland  rose  in  2008  and  2009  –  despite  2009  being  a  year  when  world   output  fell  by  over  2%  and  global  trade  contracted  by  more  than  10%.  Exports  of  goods   and  services  rose  14%  between  the  years  2007  and  2009,  surely  some  connection  here   with  the  50%  depreciation  of  the  nominal  exchange  rate?   Price  Elasticity  of  Demand  for  Exports   You  might  consider  using  some  of  the  data  in  Figure  4.2  and  Figure  4.3  to  estimate  a   price  elasticity  of  demand  for  Icelandic  and/or  Latvian  exports.   For  example,  between  2007  and  2009,  the  Icelandic  exchange  rate  depreciated  by  49%.   Assuming  that  this  fed  through  to  lower  prices  for  Icelandic  products  in  global  markets,   demand  for  exports  (reflected  in  export  volumes)  increased  by  14%  over  the  same   period.  This  implies  a  fairly  low  price  elasticity  of  demand  (14%/49%  x  100  =  0.28).     But  keep  in  mind  that:   • Exporters  do  not  necessarily  have  to  lower  their  export  prices  in  response  to  a   weaker  exchange  rate;  instead  they  may  choose  to  hold  prices  fairly  constant   and  take  a  higher  profit  margin  from  each  overseas  sale  
  12. 12. • Many  other  factors  affect  export  demand  other  than  price,  for  example  changes   in  real  disposable  incomes  in  the  economies  of  a  nation’s  main  trading  partners.   2009  was  a  year  of  severe  recession  throughout  most  of  Europe     On  the  surface,  both  Iceland  and  Latvia  have  seen  a  relatively  strong  increase  in  export   volumes  since  2007  but  they  have  got  there  in  different  ways.     Icelandic  exports  were  22%  higher  in  2012  than  they  were  in  2007.  Latvian  exports   were  16%  higher.     Comparing  import  volumes     The  third  chart  in  Figure  4.3  tracks  the  volume  of  imported  goods  and  services  into   Iceland  and  Latvia.  As  before  the  data  is  annual,  in  index  number  format  and  in  real   terms  with  a  base  year  of  2007.   The  volume  of  imports  into  Iceland  and  Latvia  was  falling  during  2008  and  collapsed   during  2009  –  in  both  cases  imports  were  over  a  third  lower  in  2009  than  two  years   earlier.  In  the  years  since,  Latvia  has  seen  her  imports  recover  more  strongly  –  reaching   86%  of  the  2007  level,  whereas  in  Iceland  in  2012,  imports  remain  23%  lower  than  in   2007.   Consider  the  causes  of  the  steep  fall  in  import  demand  in  2009  especially  –  in  both   countries  there  was  a  deep  recession  causing  real  incomes  and  employment  to  contract.     Think  here  about  the  income  elasticity  of     • Iceland:  Between  2007  and  2009:   o Real  GDP  or  real  national  income  fell  by  9%,  import  volumes  dropped  by   37%  -­‐  suggesting  an  income  elasticity  of  demand  of  +4.1  (strongly   income  elastic)   • Latvia:  Between  2007  and  2009:  
  13. 13. o Real  GDP  or  real  national  income  fell  by  21%  and  import  volumes  fell  by   41%  -­‐  suggesting  an  income  elasticity  of  demand  of  +1.95  (again  income   elastic  but  less  so  than  Iceland)   Putting  the  three  charts  that  form  Figure  4.3  together  here  are  some  summary  thoughts:   1. Latvia’s  recession  was  significantly  worse  than  Iceland’s  –  it  was  a  more  clearly   defined  V  shape  with  a  dramatic  loss  of  real  national  output  but  a  stronger   rebound  in  2011  and  2012   2. In  both  cases,  real  GDP  was  well  below  the  2007  peak  by  the  year  2012  –  a   similar  position  experienced  by  the  UK  economy  and  discussed  in  earlier   extracts   3. Iceland  managed  to  avoid  an  export-­‐led  recession  –  helped  by  her  depreciation  –   did  Iceland  take  most  of  her  pain  through  the  exchange  rate  rather  than  the   unemployment  rate?   4. In  all  three  chosen  charts,  Latvia  has  seen  a  faster  rebound  in  real  GDP,  exports   and  import  volumes  but  that  is  unlikely  to  be  the  sole  result  of  an  internal   devaluation.  Deep  recessions  often  provide  opportunities  for  an  economy  to   bounce  back  because  of  the  large  amount  of  spare  capacity  that  becomes   available.   Much  useful  data  is  missing  from  Extract  4  –  for  example,  we  are  provided  with  data  on   export  and  import  volumes  but  no  actual  data  the  current  account  balance  for  Latvia  or   Iceland.  This  would  allow  us  to  consider  for  example,  whether  a  depreciation  of  the   exchange  rate  (for  Iceland)  has  helped  bring  about  a  sustained  improvement  in  her   trade  balance  (net  trade)  or  whether  there  have  been  J  curve  effects  on  the  trade   balance  in  the  immediate  aftermath  of  the  declining  currency?   No  data  is  provided  on  relative  unit  labour  costs  for  the  two  countries,  or  their   rankings  in  terms  of  international  competitiveness.  We  are  not  told  the  scale  of  the   decline  in  nominal  or  real  wages  (an  important  aspect  of  the  internal  devaluation   debate)  or  what  has  happened  to  consumer  price  inflation  in  the  two  countries.   As  support  for  your  study  of  this  case  study,  we  have  produced  a  broad  overview  of  the   macroeconomic  performance  of  Iceland  –  this  comes  next  and  might  be  useful  in   understanding  the  context  for  Extract  4.   AD-­‐AS  Analysis  of  Exchange  Rate  Depreciation  
  14. 14. Our  analysis  diagram  shows  that   • A  significant  depreciation  of  a  currency  ought  to  provide  a  boost  to  aggregate   demand  arising  from  an  improvement  in  net  exports  (X-­‐M)   • The  effect  of  a  currency  depreciation  depends  in  part  on  the  price  elasticities  of   demand  for  exports  and  imports  and  also  the  elasticity  of  supply  of  producers  in   the  domestic  economy   • A  lower  exchange  rate  also  causes  the  prices  of  imported  products  to  rise,   causing  an  inward  shift  of  short  run  aggregate  supply   • The  standard  impact  is  that  real  GDP  growth  is  higher  (at  least  in  the  short  run)   but  that  cost-­‐push  inflationary  pressures  also  rise,  leading  to  an  increase  in  the   general  price  level.       Price   Level Real  Nati Outpu LRAS Y1 SRAS1 AD  =  C+I+G+X-­‐M Ye AD2  from  lower   currency  (Increased  X   and  fall  in  M) Y2     SRAS2  (higher   import  prices)   Y3 P1 P2