While basking a sustained period of rapid economic growing and increasing prosperity, it one time appeared that the Latvian economic system was about effortlessly converging towards its new European Union ( EU ) spouses post-accession in 2004. Indeed in the period 2005-2007, before recession hit the Republic of Latvia, one-year existent growing in gross domestic merchandise ( GDP ) averaged beyond 11 % , unemployment hit depressions of 6 % and ( table 1 of annex II ) .
Due to the openness of the late acceded EU member province, this growing nevertheless was compounded by the accretion of external instabilities with a recorded current history shortage of the order of -21.8 % of GDP in 2007 ( table 1 and figure 4 of extension I ) . Furthermore, marks of overheating of the Latvian economic system were ubiquitous. Huge degrees of accessible private funding ( largely euro-denominated, and via the foreign owned banking sector ) were used for mortgage loans and therefore ensuing in rapid additions in existent estate monetary values ( EC, 2010, pp.14 ) ; significant nominal pay growing ( Figure 5 ) ; and rises in regulated monetary values and the monetary value of nutrient reinforced these wage-related cost dazes to procure ‘inflation striking record highs ‘ ( EC, 2008a, pp.83 ) as the Consonant Index of Consumer Prices ( HICP ) surpassed 15 % ( table 1 ) .
To the surprise of many the flourishing advancement of a post-transition success narrative, nevertheless came to an disconnected arrest in 2008 as the wheels of the Latvian auto destabilised and the economic system entered into recession by the 2nd one-fourth of 2008 with negative GDP growing of -1.8 % ( figure 1 of extension I ) . The initial recession can in big portion be attributed to the reasonably speedy diminution of growing below -4 % in both the trade and industrial sectors of the economic system ( figure 2 of extension I ) following ‘a pronounced slowing ‘ in domestic demand ( EC, 2008a ) . By the 3rd one-fourth, the recession had deepened and the 2.26 million dwellers of Latvia in anticipating a farther moderation of house monetary values contributed to a crisp contraction in the overheated building market by -7.9 % ( figure 2 ) .
The planetary economic and fiscal crisis sparked off by the dramatic failure of the Lehman Brothers Investment Bank in September 2008, aggravated the downswing in the domestic Latvian economic system. At a clip of low consumer and concern assurance, the crisis led to a attendant downswing in external demand as Latvia ‘s EU and eastern European spouses ‘ economic systems import demands eased ( EC, 2008a ) . Whilst the consequent fastening recognition handiness and increasing caution of Bankss amplified the reversals in loaning and house monetary values ( EC, 2008b ) in a ‘self-reinforcing spiral ‘ ( EC, 2010, pp. 15 ) .
As the planetary fiscal crisis deepened and such reenforcing mechanisms became more utmost, the little Baltic economic system found itself exposed by the structural and external instabilities it had accumulated in the old old ages of growing ( LREM, 2009b ) . The progressively risk averse international environment and deficiency of entree to external funding was starkly brought to visible radiation when Latvia ‘s 2nd largest domestic bank, Parex ran into important jobs taking to its ultimate nationalization in November 2008 ( EC, 2009a ) .
By twelvemonth terminal 2008, unable to finance its external shortages and demoing no marks of internal recovery, the Latvian economic system was brought to the really threshold of economic prostration. The authorities was forced to give a portion of its sovereignty and bend to institutional funding for aid and was punctually granted an exigency loan deserving a‚¬7.5 billion from the International Monetary Fund ( IMF ) and the EU, conditional on the execution of certain reforms. ( IMF, 2009 )
The recession nevertheless showed no such clemency, as the double contraction in domestic and external demand persisted ( Figure 3 ) lending to a bead in existent GDP growing averaging -18.6 % over the first 3 quarters of 2009 ( Figure 1 ) ; degrees of diminution ‘on a graduated table seldom seen in peacetime ‘[ 1 ]. Indeed, in the brief period of two old ages since the beginning of recession in early 2008, Latvian losingss of end product are estimated at 25.5 % of GDP ( Weibrot and Ray, 2010, pp.5 ) . Possibly the lone top is that the prostration in domestic demand drastically reduced imports and helped switch the current history into excess by the 4th one-fourth of 2008 ( Figure 4 ) .
In add-on to the record end product losingss, the labor market besides suffered well. Since the oncoming of recession unemployment rates increased dramatically from pre-crisis degrees of below 6 % to about 19 % by 2009:3 ( Figure 1 ) and we have every bit borne informant to monolithic decreases in engagement rates as many Latvian dwellers withdrew themselves from the work force, mostly via outward migration or early retirement ( EC, 2008b and LREM, 2009a ) . Such violent displacements in labour market results have served to stoke socio-political tensenesss, which in their rawest signifier culminated in the street protests that verged on public violences on January 13 and a prostration in authorities on February 20, 2009.
A farther unwanted effect of the recession is the impact this had on the province of public fundss. Naturally, as the figure of unemployed escalated as did demands and demands for societal transportations but these automatic stabilizers are comparatively low compared to the EU-27 norm as can be seen in table 2. More well in the instance of Latvia, following such a fleet important diminution in domestic demand and exports, revenue enhancement grosss from collected incomes ( both person and corporate ) and expenditures ( peculiarly VAT ) suffered a attendant impairment. By the terminal of 2008, the Latvian Central Government ‘s basic budget revenue enhancement grosss began to decrease. In 2009, such grosss experienced a diminution of 31.5 % or 1663 million lat compared to 2008 ( LREM, 2009b ) . In concrete footings of the increasing fiscal authorities liabilities that such rapid impairment imposes, the general authorities debt increased from 9 % in 2007 to 19.5 % in 2008 following the deliverance of Parex Bank ( LREM, 2009b ) , and is estimated to hold, on norm, been of the order of 33 % in 2009 ( EC, 2009b and EC, 2009c ) .
Although it can be expected that the national economic recovery of Latvia, in the coming old ages, will ‘depend greatly on how fast [ the ] planetary fiscal system and chief spouse states of Latvia ‘s foreign trade will pick up growing once more ‘ ( LREM, 2009b ) , happening the right balance of pecuniary and financial policies is of the extreme importance. This paper contends with analyzing the policy response pursued therefore far by the Latvian Government, its ‘fiercely independent ‘ Central Bank, and the transnational IMF/EU initiated programmes. Through this we seek to foreground the errors that may hold contributed to suppressing recovery every bit good as to cast visible radiation on the chances for recovery and possible issue schemes available to the Republic of Latvia during these disruptive times of planetary economic and fiscal crisis.
Monetary Policy under Constraint: Keeping a Hard Peg
The Latvian authorities and its independent cardinal bank both portion the aim of adhering to the necessary Maastricht convergence standards necessary to guarantee that the Republic joins European Monetary Union ( EMU ) and introduces the EU individual currency ( the euro ) every bit shortly as possible ( LREM, 2009b ) . Equally far as pecuniary policy is concerned this means that it is necessary to carry through 2 cardinal standards: a sustainable grade of monetary value stableness ( in footings of rising prices and long-run nominal involvement rates ) ; and to take part in a fixed exchange rate mechanism ( ERMII ) against the euro whilst esteeming the fluctuation border of A±15 % for at least two old ages without terrible tensenesss.
In order to signal farther committedness and enhance credibleness, the Latvian cardinal bank, which entered the ERMII on the 2 May 2005 one-sidedly, adopted a 1 % difficult nog to the euro. Given free capital flows, and following Mundell ‘s celebrated ‘macroeconomic trilemma ‘ , this quasi-currency board government in enforcing an exchange rate aiming government needfully sacrifices the standard instrument for rising prices direction by pecuniary policy – the involvement rate.
As ascertained prior to the crisis, and as the Balassa-Samuelson consequence would foretell, this nog contributed to fuel domestic rising prices via lower existent involvement rates. In theoretical Balassa-Samuelson footings, the higher productiveness additions in the tradable sector inflate monetary values in the non-tradable sector ( such as existent estate ) , on the premises that PPP holds ( or at least in closer to keeping ) in the tradable goods sector, and that the euro monetary value is held exogenic, as the equation below shows:
( 1 )
As is now seen post-shock, the nog ‘s restraint on independent pecuniary policy leaves merely limited and possibly painful options for accommodation as issue is fraught with dangers for Latvia in footings of a loss of assurance in the cardinal macroeconomic stableness of the economic system, every bit good as the potency that issue could trip contagious disease kineticss, taking to jobs within the wider Baltic part and possible competitory devaluations ( EC, 2010 ) .
Opinion from academic perceivers, internal and external establishments over the virtues of the nog in the context of the present planetary crisis differs and as a consequence many differing visions for pecuniary policy ‘s function as a redress to the Latvian economic system ‘s ailments have been offered. These viing prescriptions fit loosely into two cantonments: those that argue that given the forfeits and possible dangers implicit in a fixed exchange rate government such as Latvia ‘s, merely an forsaking of the nog via devaluation or immediate Euroisation will do to return the economic system to the way of growing ; and those that, on the other manus, support the care of the bing government and seek competitory and macroeconomic accommodation via alternate mechanisms.
First, harmonizing to oppositions of continuing Latvia ‘s place in the ERMII system, it is noted that as the planetary crisis filtered out and deepened, the existent exchange rate remains overvalued as ‘trading spouse currencies [ non pegged to the euro ] have depreciated aggressively ‘ ( IMF, 2009, pp.11 ) . Table 1 shows that the existent effectual exchange rate appreciated during the period 2005-2008 and this has subsequent to the crisis response merely dropped 5.8 per centum from its extremum in 2008 ( Weibrot and Ray, 2010 ) . The deficiency of existent effectual exchange rate to turn the footings of trade more in favor of the lat is non merely explained by depreciations of the nominal exchange rate of Latvia ‘s major trading spouses, but besides because of the limited sum of downward monetary value and pay flexibleness ( CEPR, 2010 ) significance that the spread in fight under the nog persists therefore clogging chances for growing.
Such a misalignment every bit good as ensuing in a shortage in fight, can show other, more terrible jobs such as capital flight. To the extent to which the lat is perceived as being overvalued and expected to be adjusted, hazard premiums spread as investors fear a possible prostration and mounting bad onslaughts, . Indeed, as figure 6 shows, the IMF undertakings that in 2009 Latvia had a entire fiscal and capital history shortage of a‚¬4.2 billion and that a farther a‚¬1.5 billion is set to go forth in 2010 ( CEPR, 2010 ) . To antagonize this procedure and reinstate credibleness and support the Latvian difficult nog against the euro, the Central Bank needfully needed and still needs, to curtail capital flight ( via house committednesss every bit good as by the sale of foreign exchange, FX, militias ) . As a effect the exchange rate uncertainness that is created by the nog, harmonizing to Weibrot and Ray ‘harms the full investing clime ‘ ( pp.10 ) .
Another negative effect associated with the care of a difficult nog in the visible radiation of the economic and fiscal crisis is that, without a devaluation that could in rule stimulate external demand, an increased figure of non-performing loans and defaulting debitors will ensue as the Latvian tradable goods sector continues its contraction.
However, in malice of the statements against the difficult nog of the lat to the euro as discussed above, the Latvian Central Bank and Government have ‘remain [ erectile dysfunction ] strongly committed to the care of their long-standing pecuniary and exchange rate agreements ‘ throughout the crisis period ( EC, 2010 ) . In support of this, under the conditions of the IMF and EU bailout loan it was specified that the ERMII government be maintained.
The statement for care of the nog derives foremost from a belief in its function as an ground tackle for stableness and secondly on the dismissal of possible large-scale capital flight due to the auxiliary ground tackle of bilateral and many-sided committednesss from foreign investors ( peculiarly the Norse Bankss ) to stay and supply support to their subordinates as so they have therefore far done.
Furthermore, devaluation is discounted as a existent alternate since the attendant negative balance effects far exceed any negative effects due to a undertaking export sector. If one considers the 89 % of Latvian occupants ‘ and the Latvian corporations whose debt is denominated in foreign currency ( IMF, 2009b, pp.11 ) , one sees that devaluation, in doing these debts larger would hold the unwanted direct consequence of suppressing private ingestion and investings even farther, every bit good as taking to a farther tightening in recognition as expected bank losingss mount ( EC, 2010 ) . For this ground, the Central Bank argues that devaluation would put off a concatenation of loan defaults and finally run the hazard of complete fiscal prostration, therefore holding the net consequence of any devaluation being contractionary ( CEPR, 2010 ) .
Furthermore, in response to the rule that after an initial slowdown due to the J-curve consequence devaluation can assist hike exports, protagonists of the position quo maintain that the remarkably weak demand for Latvian exports given the utmost planetary downswing, could restrict any permanent benefit of devaluation in supplying a positive export stimulation. This coupled with the Latvian economic system ‘s comparative high import content of exports and its high portion of imports in aggregative outgo ( EC, 2010 ) may arouse domestic rising prices as import monetary values rise and therefore farther cut down the Baltic economic system ‘s fight.
In the recent academic argument, mostly carried out in the blogosphere, it has been emphasised that, basically, retrieving monetary value fight via disinflationary procedures while maintaining the current nog or via nominal depreciation would take to the same result on debt service ( Hugh, 2008 )[ 2 ]. IMF and EU support for the Latvian penchant for the former ‘internal devaluation ‘ policy attack instead than an forsaking of the nog is besides driven by the desire to back up ( to a certain extent ) the autonomous wants of the Latvian authorities. Insofar as it is felt that any policy attack can merely be successful if those closest to the levers of control are of what lever to draw i.e. ‘national ownership of the chosen scheme is cardinal ‘ ( EC, 2010, pp. 98 ) . Before turning to discoursing this chosen policy way of ‘internal devaluation, ‘ given the necessary accent on the function of financial policy in this accommodation scheme, it shall turn out expedient to foremost put the Latvian financial government into its rightful context.
Fiscal Policy Context
With pecuniary policy limited to the function of keeping the difficult exchange rate nog, the function of discretional financial policy in presenting Latvia from crisis becomes important. However, as noted in the debut, the recession had the impact of taking to the impairment in Latvia ‘s public fundss and a less positive mentality for their sustainability go forthing small room for countercyclical policies to reconstruct some of the lost internal demand and seek to ‘lean against the air current. ‘
Furthermore, in order to maintain in line with the Government aim of guaranting euro acceptance at the first possible minute, it is necessary for Latvia to maintain maintain prudent control of these fundss to fulfill the two public finance sustainability based Maastricht standards: the ratio of authorities shortage to GDP should non transcend 3 % ; and the ratio of authorities debt to GDP can non transcend 60 % . Given that big budget shortages every bit good as curtailing room for discretional financial accommodation besides have as a effect higher involvement rates, which in bend, can take to snowball effects ( high rates of involvement on the debts means that even a budget excess do non needfully cut down the authorities debt load ) therefore augmenting the hazard of blowout debts and authorities default. It follows hence that any Keynesian financial policy directed at reconstructing Latvian demand would necessitate to be taken with one oculus on the Maastricht standards and the sustainability of public fundss.
Notwithstanding the demand for cautiousness in ordaining countercyclical financial policy highlighted above, at the beginning of the recession, the Latvian authorities budget of November 2008 was ab initio ‘very expansionary ‘ ( EC, 2008b ) and included the determination to raise both the non-taxable net incomes threshold and the minimal pay, whilst denoting merely modest revenue enhancement rises on oil and baccy merchandises ( EC, 2008c, pp.236 ) . Meanwhile, public sector rewards were besides forecast to go on to increase quickly ( EC, 2008a pp.83 ) and a personal income revenue enhancement decrease from 25 to 23 % ( LB, 2009a, pp.35 ) and generous pension additions in 2008 contributed to greater budget spendings ( EC, 2009a, pp. 79 )
However due to the progressively deteriorating nature of the financial place, and peculiarly after the deliverance of Parex Bank, there shortly remained small pick but to follow a scheme of consolidation. Indeed, when the IMF and EU agreed to supply a bailout fund to the Latvian governments, and efficaciously took control of the way of their financial policy, among the rigorous conditions it was stipulated that the turning debts impeded any farther room for countercyclical tactics and that alternatively a scheme financial retrenchment was necessary to back up the broader policy of macroeconomic stabilization via ‘internal devaluation ‘ to which we now turn.
IMF to the Rescue: ‘Internal Devaluation ‘
Following the December 2008 determination to conditional supply Latvia with a a‚¬7.5 billion euro bailout loan, attached to this understanding the IMF and the EU placed certain conditions that it felt necessary to assist Latvia efficaciously exit the crisis. With the exchange rate fixed and independent pecuniary policy therefore denied, they alternatively opted to set the existent exchange rate via ‘internal devaluation through pay and monetary value diminutions ‘ ( IMF, 2009 ) .
There is range for this within the Latvian economic system, the transnational grouping of loaners believe, since the predating old ages of roar, led to pay growing above and beyond additions in productiveness in both the populace and private sector and hence that there exists room for competitory betterments via widespread pay moderateness and cuts ( LREM, 2009b ) . Furthermore, it is felt by the loaners that the ‘flexibility of the [ Latvian ] economyaˆ¦ and the fact that dual digit negative growing rates are more tolerable after about a decennary of really strong growing ‘ makes such imposed pay cuts more politically executable ( EC, 2010 pp.16 ) .
Such a scheme, which needfully imposes a heavy accommodation load, is of class non without its oppositions. First and first, shamelessly the policy is procyclical. This will further worsen the recession by raising revenue enhancement loads and cut downing borders for growing heightening authorities policies therefore diping any growing chances for ‘some clip in front ‘ ( EC, 2010 ) . In its first reappraisal of the conformity of the Latvian policy response, the IMF acknowledges this fact though it suggests this to be merely a short-run cost stating that the tight financial stance ‘will probably do continued demand failing through early 2010 ‘ IMF ( 2009 ) .
What ‘s more, given the context of planetary crisis and the Latvian authorities ‘s deficiency of path record, in order to be believable and effectual at smoothing the rhythm, discretional policy in Latvia demands to be bold. Boldness is necessary in order to bring forth an impact on debt stabilization in profiting from ‘reverse Keynesian multiplier ‘ effects, which are likely to be reasonably ‘small in visible radiation of the high grade of openness ‘ of the Latvian economic system ( EC, 2010 ) . Bold outgo cuts or revenue enhancement hikings are besides of import for their ‘non-Keynesian consequence ‘ as by get downing some tough medical specialty, the Government is able to show a more believable committedness to financial subject.
As a direct effect of the potentially protracted and crisp short-run hurting, given that since public penchant for public-service corporation now instead than in the following clip period, it follows that if betterments happen easy or the asceticism bundles are considered excessively painful, public support will dwindle and the reform train will put on the line crunching to a arrest as the political will yield to ‘reform weariness ‘ . Prolonging the recession via procyclical budget cuts can besides make other long-run economic costs in that the long-run unemployed lose their accomplishments and motive or if public investings in keeping substructure do non happen.
In add-on, the range for monetary value and pay deflation in Latvia is limited by the freedom of motion enjoyed in the Single EU Market ( EC, 2009b, pp.112 ) . Following Tieboutian theory of inter-jurisdictional competition, if Latvians are unhappy about the lowered domestic safety cyberspace and diminution in public service proviso, they will merely ‘vote with their pess ‘ and emigrate, and do their part to another member province ‘s economic system and budget.
In the longer term, nevertheless, the IMF and EU argue that the accommodation will exercise a positive function by reconstructing monetary value fight and ‘steer market outlooks towards stableness ‘ ( EC, 2010 ) . Now, holding discussed briefly the comparative theoretical virtues of an internal devaluation, we now turn our attending to weighing up the comparative success of the specific consolidation policies adopted by the Latvian governments in response to the crisis as it evolved during late 2008 and 2009.
The Path of Fiscal Retrenchment
By terminal 2008, the Latvian authorities had agreed to the IMF proposed bundle and sought steps to carry through the demands of financial tightening and in peculiar public sector pay decreases. Soon the bundle, which the authorities has agreed to, requires a financial tightening of 6.5 % of GDP by 2010 ( IMF, 2009 ) . In order to accomplish this Latvia has to day of the month undertaken two major unit of ammunitions of consolidation, one in December 2008 and the other on the 16th June 2009 ( IMF, 2009 ) .
The first unit of ammunition of cutbacks focused on pay decreases for public sector workers and an addition in excise revenue enhancements and the VAT rate ( LREM, 2009a ) . This first bundle was on paper extremely ambitious, trusting to accomplish cuts deserving 7 % of GDP ( peculiarly impressive given this auxiliary budget replaced the proposed expansionary budget of merely one month prior ) . However, possibly unsurprisingly in operation a big portion of the plan remained unimplemented possibly reflecting a ‘ratchet consequence ‘ , whereby it is easy to increase outgos but much harder to cut down them, whilst the VAT and strike rises really meant revenue enhancement grosss fell as domestic demand was further weakened by the harsher than expected downswing ( LB, 2009b, pp.38 ) .
In the 2nd financial bundle the old defects were sought to be overcome and surpassed, though this was delayed by two months due to a alteration in authorities. Under a fresh public authorization, the new authorities put pensions and health care under the knife. Pensions were slashed by 70 % for working pensionaries and sliced by 10 % for those non working ( LREM, 2009b ) . This enabled province parts to the national pension strategy to be cut by 2 % . Meanwhile, instruction is capable to targeted cuts of 50 % and health care was capable to cuts of around 33 % every bit good as a figure of structural reforms taking to the surrender of the wellness curate ( IMF, 2009, pp.46 ) .
It is hard to see how such wide and indiscriminate cuts in indispensable disbursement will hold a good long-run consequence on the Latvian economic system, peculiarly given the comparatively little initial size of Latvian public outgos. These sentiments are echoed by the World Bank, who harmonizing to the IMF is peculiarly ‘concerned with the crisp cuts in instructor rewards, [ which ] will deter new entrants to the instruction profession, worsen the quality of instruction, and undermine long-run growing ‘ ( IMF, 2009, pp.46 ) .
On the footing of the proposals the Latvian Economics Ministry forecasts that in 2010-2012 cardinal authorities debt degree will non transcend 60 % of GDP ( LREM, 2009b ) . Initial marks of pay moderateness are clear though modest as mean rewards in the 3rd one-fourth of 2009 declined by 5 % as figure 5 exhibits. The public histories in 2009 though remain steadfastly in shortage and below Maastricht degrees ( -5.9 % , table 1 ) as the consolidation of public fundss proves hard in the context of such a terrible recession.
It is hence recognized that financial retrenchment entirely is non sufficient to reconstruct the public debt sustainability necessary to reassure markets of Latvian macroeconomic stableness. A late published EC study on the Baltic economic systems ( EC, 2010, pp.96 ) highlights several enterprises approved in the 2009 budget that can potentially assist lift the state out of recession and onto a more sustainable way of growing. Most interestingly, this list includes efforts to re-orientate the economic system to capital intensive export industries ( and off from building ) by extinguishing revenue enhancements on net incomes from the sale of hi-tech industries.
Additionally, to understate the growth-dampening consequence of lower public outgo, the EU structural financess are to be ‘frontloaded ‘ to supply for some substructure, technological and human investing ( EC, 2009c, pp.228 ) . It should be noted though that these financess, valued a‚¬2100 per capita ( EC, 2010 ) , will probably crowd-out domestic investing and may bring on jobs of dependence in later periods.
The Latvian economic system is still trembling from the daze of recession and planetary downswing that hit in late 2008. As a effect of this daze the governments were required to seek external fiscal support from the IMF and EU in order to brace the macroeconomic system and avoid complete prostration. The chosen way to recovery has so far been based on three overarching rules: defend and keep the difficult nog ; ‘internally devaluate ‘ via deflation to accomplish existent fight ; and consolidate financial shortages to brace the ‘snowballing ‘ debt to remain in line with the Maastricht standards for euro entry.
Oppositions to such a scheme on macroeconomic evidences fear that in keeping the nog, the Latvian governments are supporting the untenable repeating Argentina ‘s currency board prostration in 2002 ( see for case Weibrot and Ray ( 2010 ) . Whilst the World Bank, and sky high unemployment, suggests that the strivings of internal rebalancing and financial retrenchment may outweigh the costs. The option, they suggest, is to orchestrate a devaluation ( contained or otherwise ) so as to realine exchange rates and reconstruct Latvian fight in export markets. However, there is no warrant that a sufficient devaluation will be achieved and weighing the ground tackle of the difficult nog may ask for further bad onslaught and given the extent of the deficit on external demand it is expected that a big devaluation would be needed. ( EC, 2010, pp.99 )
Latvian chances of recovery remain clouded by ‘a series of economic, fiscal, and socio-political hazards of both domestic and foreign beginning ‘ ( EC, 2010 pp.14 ) . In peculiar, how the accommodation interacts with chances for growing will mostly depend on recovery elsewhere and how successful the scheme is in debaring destabilizing force per unit areas on the current nog. In brief, the route to recovery for the Republic of Latvia, whichever form it takes, is traveling to be a long, unsmooth one.