Lessons from Latvia's internal adjustment
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The document discusses Latvia's experience during the 2008 financial crisis and recovery. It explains that Latvia chose an internal devaluation through austerity and structural reforms rather than devaluing its currency. This led to a rapid but difficult adjustment period and a "V-shaped" economic recovery. Key factors in Latvia's success included speed of implementation, ownership of reforms, commitment to change, and national solidarity. The internal adjustment approach stabilized public finances, restored competitiveness and exports, attracted foreign investment, and put Latvia in a strong position to adopt the Euro in 2014.
Lessons from Latvia's internal adjustment
- 1. Lessons from Latvia’s internal adjustment Ilmārs Rimšēvičs Governor of the Bank of Latvia March 1, 2012
- 2. 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 Government Commercial Labour FDI EU Funds Latvia budget Banks remittances 1 EUR = 0.702804 LVL
- 3. Labour market overheated significantly, driving wages above productivity and hurting competitiveness Wages and productivity, 2000=100 200 190 180 170 160 150 140 130 120 2004 2005 2006 2007 2008 Productivity Real wage Source: CSB, Bank of Latvia staff calculations
- 4. Excessive demand showed up in massive current account deficits Current account balance, % of GDP 0.0 -5.0 -6.7 -8.2 -10.0 -12.9 -12.6 -15.0 -20.0 -22.6 -22.4 -25.0 2002 2003 2004 2005 2006 2007 Source: Bank of Latvia
- 5. GDP was pushed up by banks borrowing abroad and channelling funds into economy to nurture massive lending boom, until the bubble collapsed Credit to residents, % y-o-y 70 +60.4 60 50 40 30 20 10 0 -8.2 -10 I 2011 I 2004 I 2005 I 2006 I 2007 I 2008 I 2009 I 2010 I 2012 Source: Bank of Latvia
- 6. Latvia at the outset of the recent crisis Many suggested devaluation as a way out of the crisis. Why devaluation was not an appropriate solution?
- 7. 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
- 8. 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
- 9. Despite loud ex ante warnings of protracted recession risks under internal adjustment scenario, a strong “V” shaped recovery followed Real GDP growth, % 15 10 5 5.3 0 -5 -10 -15 -20 2006 2007 2008 2009 2010 2011F Source: CSB; F – Bank of Latvia forecast
- 10. 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
- 11. Indeed, Latvia and other Baltic countries have clearly benefited from getting through the internal adjustment at an early stage GDP growth in 2011, % y-o-y 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 Latvia Sweden* Ireland* Cyprus Spain France Slovenia* Poland* Greece* Italy* Hungary Portugal* Bulgaria* Austria Lithuania Slovakia Netherlands Malta* Finland Belgium* UK* Czech Rep.* Estonia Romania* Luxembourg* Germany Denmark* Source: Eurostat; * - EC Interim Forecast (February 2012) for those countries, whose GDP data is not yet available for the year as a whole
- 12. How Latvia managed to accomplish what initially was claimed being impossible? Speed Ownership Commitment Solidarity
- 13. 0 5 -5 10 15 20 Estonia Source: Eurostat Lithuania Czech Republic Latvia Romania Slovakia Bulgaria Spain Hungary Sweden Germany Slovenia Austria Denmark Italy Portugal Poland Belgium United Kingdom France Netherlands Cyprus Ireland Luxembourg Iceland Finland Greece Latvia ranges among the export leaders in Europe Exports already well above the pre-crisis peak level; Real growth in exports of goods and services, first three quarters of 2011, % y-o-y Malta
- 14. 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 = 100 150 140 130 120 110 100 90 80 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 Labour productivity Real wage Source: CSB; Bank of Latvia staff calculations
- 15. 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=100 220 210 Bulgaria 200 Czech Republic 190 Estonia 180 170 Hungary 160 Latvia 150 Lithuania 140 130 Poland 120 Romania 110 Slovakia 100 Slovenia 90 2002 2003 2004 2005 2006 2007 2008 2009 2010 Q1 Q2 Q3 2011 Source: WTO
- 16. External imbalances have been corrected quickly: current account remains close to balance Balance of Payments, % of GDP 15.0 8.6 10.0 5.0 3.0 -0.5 -0.6 0.0 -5.0 -10.0 -15.0 -13.1 -20.0 -25.0 -22.6 -22.4 2006 2007 2008 2009 2010 2011F 2012F Goods and services Income Current transfers Current account Source: Bank of Latvia; F – Bank of Latvia forecast
- 17. Latvia has regained investor confidence Net FDI inflows, mln LVL (ex banking and real estate, moving average) 160.0 Net FDI inflows in 2011: 140.0 5.8% of GDP 120.0 100.0 80.0 60.0 40.0 20.0 0.0 -20.0 -40.0 IV II IV II IV II IV II IV II IV II II IV II III III III III III III III III I 2005 I 2011 I 2004 I 2006 I 2007 I 2008 I 2009 I 2010 IV* Source: Bank of Latvia; * - preliminary data
- 18. In contrast to countries that responded to crisis by devaluing and imposing capital controls, Latvia has experienced a strong rebound in investment Gross fixed capital formation, % y-o-y 40 28.6 30 24.4 21.9 20 10 0 -10 -20 -30 -40 -50 IV IV II IV II II IV II II III III III III III I 2008 I 2007 I 2009 I 2010 I 2011 Source: CSB
- 19. With sizeable fiscal adjustment budget balance is expected to reach sustainable levels General Government balance (ESA’95), % of GDP 0 -0.4 -1.0 0.0 -2.5 -2 -4.0 -4.2 -4 -8.3 -9.7 -6 -8 -10 -12 -14 -16 -18 -20 2007 2008 2009 2010 2011 2012F 2013F 2014F Consolidation effort Actual (targeted) balance Source: Eurostat, BoL staff estimation
- 20. Public debt has stabilized at around 45% of GDP; well below initially expected peak of close to 100% of GDP General government gross debt (ESA95), % of GDP 60 50 40 30 20 10 0 2007 2008 2009 2010 2011F 2012F Source: Eurostat; F -Bank of Latvia forecast
- 21. 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, % 5 4 3 2 1 0 Maastricht criteria* -1 -2 12 month average inflation -3 I 2010 IV VII X I 2011 IV VII X I 2012 IV VII X I 2013 IV VII X Source: CSB, EC autumn 2011 forecast; Bank of Latvia forecasts and staff calculations
- 22. The aim of introducing Euro in 2014 is well within reach General Government budget balance (ESA95), % of GDP 0.0 0.0 -1.0 -0.4 -1.0 -2.0 -3.0 -2.5 -4.0 -4.2 -4.0 -5.0 -6.0 EURO -7.0 -8.0 -9.0 -8.3 -10.0 Budget strategy Measure- -9.7 -11.0 ment -12.0 2007 2008 2009 2010 2011 2012F 2013F 2014F Source: Eurostat, BoL staff estimation
- 24. Many European countries still suffer from weak public finance discipline Budget balance, % of Public debt, % of GDP* GDP growth, % Inflation, % GDP* 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)