Lessons from Latvia’s internal

adjustment

March 1, 2012

Ilmārs Rimšēvičs

Governor of the Bank of Latvia

Origins of the recent Crisis? The past growth was fuelled by massive capital inflows, building up excessive demand and a real estate bubble

Bank of

Latvia

1 EUR = 0.702804 LVL

Government

budget

Commercial

Banks FDI EU Funds

Labour

remittances

120

130

140

150

160

170

180

190

200

2004 2005 2006 2007 2008

Productivity Real wage

Labour market overheated significantly, driving wages above productivity and hurting competitiveness

Wages and productivity, 2000=100

Source: CSB, Bank of Latvia staff calculations

Excessive demand showed up in massive current account deficits

Current account balance, % of GDP

-6.7 -8.2

-12.9 -12.6

-22.6 -22.4

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

2002 2003 2004 2005 2006 2007

Source: Bank of Latvia

GDP was pushed up by banks borrowing abroad and channelling funds into economy to nurture massive lending

boom, until the bubble collapsed

+60.4

-8.2 -10

0

10

20

30

40

50

60

70

I 2004

I 2005

I 2006

I 2007

I 2008

I 2009

I 2010

I 2011

I 2012

Credit to residents, % y-o-y

Source: Bank of Latvia

Many suggested devaluation as a

way out of the crisis.

Why devaluation was not an

appropriate solution?

Latvia at the outset of the recent crisis

Devaluation is not a solution for Latvia

High import content in exports and domestic produc-

tion, competitive gains reduced by surge in input costs

No immediate improvement in the current account

(Marshall-Lerner condition is not met)

High share of FX liabilities: many corporates would

face negative equity immediately

Loss of credibility and likely run on banks

Court system unable to cope with sharp increase in

insolvency cases, inefficient insolvency procedure

No motivation to improve efficiency and productivity

The internal adjustment was the only path to follow

Time bought for structural reforms that

smoothen adjustment

Improvement of public sector efficiency

Less corporate bankruptcies reduce costs for the

economy

More gradual adjustment motivates businesses for

productive improvements

Latvia’s economy is reasonably flexible to adjust

Society understands the root causes of crisis and

supports necessary austerity and reforms

Despite loud ex ante warnings of protracted recession risks under internal adjustment scenario,

a strong “V” shaped recovery followed

Real GDP growth, %

5.3

-20

-15

-10

-5

0

5

10

15

2006 2007 2008 2009 2010 2011F

Source: CSB; F – Bank of Latvia forecast

Latvia has implemented sizable fiscal consolidation underpinned by structural reforms

Breakdown of budget consolidation measures, % of GDP

Source: Ministry of Finance; Bank of Latvia staff calculations

Indeed, Latvia and other Baltic countries have clearly benefited from getting through the internal adjustment at

an early stage

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Gre

ece*

Po

rtu

ga

l*

Ita

ly*

Cy

pru

s

Sp

ain

Irel

an

d*

UK

*

Den

ma

rk*

Lu

xem

bo

urg

*

Net

her

lan

ds

Hu

ng

ary

Fra

nce

Cze

ch R

ep.*

Bu

lga

ria

*

Slo

ven

ia*

Bel

giu

m*

Ma

lta

*

Fin

lan

d

Ro

ma

nia

*

Ger

ma

ny

Au

stri

a

Slo

va

kia

Sw

eden

*

Po

lan

d*

La

tvia

Lit

hu

an

ia

Est

on

ia

GDP growth in 2011, % y-o-y

Source: Eurostat; * - EC Interim Forecast (February 2012) for those countries, whose GDP data is not yet available for the year as a whole

How Latvia managed to accomplish what initially was claimed being impossible?

Speed

Ownership

Commitment

Solidarity

-5

0

5

10

15

20

Est

on

ia

Lit

hu

an

ia

Cze

ch R

epu

bli

c

La

tvia

Ro

ma

nia

Slo

va

kia

Bu

lga

ria

Sp

ain

Hu

ng

ary

Sw

eden

Ger

ma

ny

Slo

ven

ia

Au

stri

a

Den

ma

rk

Ita

ly

Po

rtu

ga

l

Po

lan

d

Bel

giu

m

Un

ited

Kin

gd

om

Fra

nce

Net

her

lan

ds

Cy

pru

s

Irel

an

d

Lu

xem

bou

rg

Icel

an

d

Fin

lan

d

Gre

ece

Ma

lta

Real growth in exports of goods and services, first three quarters of 2011, % y-o-y

Source: Eurostat

Exports already well above the pre-crisis peak level; Latvia ranges among the export leaders in Europe

Recovery was largely underpinned by regained competitiveness: wage-productivity gap has been closed

Real hourly wage and labour productivity per hour (seasonally adjusted), 2005 Q1 = 100

80

90

100

110

120

130

140

150

20

04

Q1

Q3

20

05

Q1

Q3

20

06

Q1

Q3

20

07

Q1

Q3

20

08

Q1

Q3

20

09

Q1

Q3

20

10

Q1

Q3

20

11

Q1

Q3

Labour productivity Real wage

Source: CSB; Bank of Latvia staff calculations

Export market shares increase is among the strongest in the group of new EU member states

Latvia’s merchandise export shares in world export, 2002=100

90

100

110

120

130

140

150

160

170

180

190

200

210

220

2002 2003 2004 2005 2006 2007 2008 2009 2010 Q1

2011

Q2 Q3

Bulgaria

Czech Republic

Estonia

Hungary

Latvia

Lithuania

Poland

Romania

Slovakia

Slovenia

Source: WTO

External imbalances have been corrected quickly: current account remains close to balance

Source: Bank of Latvia; F – Bank of Latvia forecast

Balance of Payments, % of GDP

-22.6 -22.4

-13.1

8.6

3.0 -0.5 -0.6

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

2006 2007 2008 2009 2010 2011F 2012F

Goods and services Income Current transfers Current account

Latvia has regained investor confidence

Net FDI inflows, mln LVL (ex banking and real estate, moving average)

-40.0

-20.0

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

I 2004

II

III

IV

I 2

00

5

II

III

IV

I 2006

II

III

IV

I 2007

II

III

IV

I 2008

II

III

IV

I 2009

II

III

IV

I 2010

II

III

IV

I 2

011

II

III

IV*

Source: Bank of Latvia; * - preliminary data

Net FDI inflows in 2011:

5.8% of GDP

In contrast to countries that responded to crisis by devaluing and imposing capital controls, Latvia has

experienced a strong rebound in investment

28.6

21.9 24.4

-50

-40

-30

-20

-10

0

10

20

30

40

I 200

7

II

III

IV

I 2

00

8

II

III

IV

I 200

9

II

III

IV

I 201

0

II

III

IV

I 2011

II

III

Gross fixed capital formation, % y-o-y

Source: CSB

With sizeable fiscal adjustment budget balance is expected to reach sustainable levels

-0.4

-4.2

-9.7 -8.3

-4.0 -2.5

-1.0 0.0

-20

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2007 2008 2009 2010 2011 2012F 2013F 2014F

Consolidation effort Actual (targeted) balance

General Government balance (ESA’95), % of GDP

Source: Eurostat, BoL staff estimation

0

10

20

30

40

50

60

2007 2008 2009 2010 2011F 2012F

General government gross debt (ESA95), % of GDP

Source: Eurostat; F -Bank of Latvia forecast

Public debt has stabilized at around 45% of GDP; well below initially expected peak of close to 100% of GDP

Current forecast scenario implies that Latvia is expected to comply with the Maastricht inflation

criteria since the beginning of 2013

Maastricht criteria estimate forecast and 12 month average inflation, %

-3

-2

-1

0

1

2

3

4

5

I 2010 IV VII X I 2011 IV VII X I 2012 IV VII X I 2013 IV VII X

Maastricht criteria*

12 month average inflation

Source: CSB, EC autumn 2011 forecast; Bank of Latvia forecasts and staff calculations

-0.4

-4.2

-9.7

-8.3

-4.0

-2.5

-1.0

0.0

-12.0

-11.0

-10.0

-9.0

-8.0

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

2007 2008 2009 2010 2011 2012F 2013F 2014F

The aim of introducing Euro in 2014 is well within reach

Measure-

ment

EURO

Budget strategy

General Government budget balance (ESA95), % of GDP

Source: Eurostat, BoL staff estimation

Many European countries still suffer from weak public finance discipline

Public debt, % of GDP* Budget balance, % of

GDP* GDP growth, % Inflation, %

2011 2012 2011 2012 2011 2012 2011 2012

Greece 162.8 198.3 -8.9 -7.0 -6.8 -4.4 3.1 -0.5

Italy 120.5 120.5 -4.0 -2.3 0.2 -1.3 2.9 2.9

Ireland 108.1 117.5 -10.3 -8.6 0.9 0.5 1.2 1.6

Portugal 101.6 111.0 -5.8 -4.5 -1.5 -3.3 3.6 3.3

Belgium 97.2 99.2 -3.6 -4.6 1.9 -0.1 3.5 2.7

Euro area 88.0 90.4 -4.1 -3.4 1.4 -0.3 2.7 2.1

France 85.4 89.2 -5.8 -5.3 1.7 0.4 2.3 2.2

EU 82.5 84.9 -4.7 -3.9 1.5 0.0 3.1 2.3

Germany 81.7 81.2 -1.3 -1.0 3.0 0.6 2.5 1.9

Austria 72.2 73.3 -3.4 -3.1 3.1 0.7 3.6 2.4

Spain 69.6 73.8 -6.6 -5.9 0.7 -1.0 3.1 1.3

Malta 69.6 70.8 -3.0 -3.5 2.1 1.0 2.4 2.1

Cyprus 64.9 68.4 -6.7 -4.9 0.5 -0.5 3.5 2.8

Netherlands 64.2 64.9 -4.3 -3.1 1.2 -0.9 2.5 2.0

Finland 49.1 51.8 -1.0 -0.7 2.7 0.8 3.3 3.0

Slovenia 45.5 50.1 -5.7 -5.3 0.3 -0.1 2.1 1.6

Slovakia 44.5 47.5 -5.8 -4.9 3.3 1.2 4.1 1.9

Luxembourg 19.5 20.2 -0.6 -1.1 1.1 0.7 3.7 2.7

Estonia 5.8 6.0 0.8 -1.8 7.5 1.2 5.1 3.1 * - marked = non compliance with Maastricht criteria

Source: EC Autumn 2011 forecasts (public finance data), EC February 2012 forecasts (GDP and inflation)