Latvia

Overview of Country Profile.

Analysis of Extract 3

Location• North-East Europe

• One of the three Baltic States

• Capital: Riga

• Land Mass: 64 500 km2

• Population: 2.2 million

• Historical dependency of: Germany, Poland, Sweden, USSR

• Independence: 1919-1941; 1991 - present

Demographics

• Shrinking Population:

Low Birth Rate - Fertility: 1.35 – 221nd globally

EU Migration

• Ethnic Split:

61% Latvians

28% Russians

3% Belarusian

Composition of GDP

• Services: 70%– IT– Transport– Wholesale– Finance

• Manufacturing: 25%– Timber– Foodstuffs– Petrochemicals– Metals– Pharmaceuticals– Construction– Candles

• Agriculture 5%– Dairies– Cereals– Potatoes– Meat

Standards of Living

• GDP per Capita: $21 920

GDP per Capita

HDI

• Index: 0.814

• Very High Income Group

2002-2007

• GDP (PPP): $33.7bn

• Real Growth Rate: 4%

• Causes:– EU Accession 2004

– Interest Rates

– Business Confidence

– Housing Market

– Consumption Boom

– Credit Boom: Inventories/Durables

– Asset Price Bubble

GDP Growth

Economic Crisis • Quarterly Contraction: 10.5%

• Output Gap: 10%

• Inflation: 18%

• Unemployment: 18.6%

• Credit Tightening

• Debt: 50% GDP

• Fitch: A+ to BBB-

• Deposit run-on

• Liquidity shortage

• 36-month Stand-By: €7.5bn

• Aims of Bailout (Conditionality):

– stem the loss of bank deposits and international reserves

– restore confidence in the banking and support private debt restructuring;

– limit the substantial widening in the budget deficit

– prepare for early fulfillment of the Maastricht criteria

– Structural reforms aimed at rebuilding competitiveness

Resolution

• Conventional method: budgetary squeeze, followed by offsetting stimulus of a currency devaluation

• Latvia’s Aim: Restore Financial Stability– Fiscal Adjustment: 17.5%

– Swiftness: Bulk Done in 2009

• Focus: Export-led Local Recovery

• Corporation Tax stable: 15%– Real Tax Rate: 2 ↓to 36%

– Emigration

• Internal Devaluation

Internal Devaluation

• Fixed Exchange Rate

– Counter-Cyclical Expansionary Policy

– Large Euro-denominated Debt Stocks

• Taxation in-payments fell 3

to 13% • Revenue stable:

26±1% of GDP

• Short-Term pain: Pro-cyclical Fiscal Adjustment Government Expenditure Cut VAT rise of 3% Public Sector Wage Cuts of 20%

• Squeeze on Labour Costs– Fall in Real Wages, mostly in public sector

– Real Unit Labour Costs fall of 20%

– Increased Productivity

• High Interest Rates

Internal Devaluation AssessedIceland Fixed Exchange Rate : NEER devaluation of 50%

• The Crisis in Latvia: deeper (20%) and V-shaped– Iceland: 10%

• Faster and More Sustainable Recovery in Latvia: 4% annual GDP:– Spare Capacity– Iceland: 2%, but relating to pre-crisis size of economy

• Exports: -10%– Iceland: +15%

• Unemployment: peak of 18%, 2013: 9.8%– 9%. 2013: 5%

• Inflation: 9% peak followed by Stability at 2%– Iceland: 12% (2009), continues at one of highest in Europe

• Sovereign Debt: Denominator Effect– Increasing Debt

• Similar Current Account situation• Competitiveness Improved• Reassurance of Investors

IMF-Parex

• Restoration of healthy levels of GDP

• Unemployment down 3%

• Competitiveness:– Macroeconomic Environment:

– Labour Efficiency: 18 ↓ to 27th

– Investors Confidence: 93rd to 29th

• Market Confidence: BBB+• Improved Government Finances: December 2012 US$ Issue at 2.75%

• Early IMF Repayment

• Current Account Normalisation

• Fiscal Discipline Law

• National Strategic Plan

Results

Competitiveness

• Transition Stage: Efficiency→ Innovation

Positive Developments: Index Rank:

44th (2007)70th (2010)52nd (2013)

Labour Market Competitiveness

Estonia Rank: 34th

Inflation Rate

Latest Developments

IMF Concluding Statement: 10/3/14“The Outlook for 2014 is Broadly Favourable”

Praise:

• 4%: Fastest Rate of Growth in Europe

• Real Effective Exchange Rate is in line with fundamentals

• Unemployment: 11.3%

• The Output Gap has been largely Closed

• A Balanced Recovery: C, I, X

Gross National Savings

• Short-Term Warnings : Dependency on Performance of neighbouring economies

– Escalation of Ukrainian Crisis

– Tapering of Unconventional Monetary Policy

– Contracting Banking Credit, hampered by private sector debt overhang

– Closure of Output Gap

• Recommendations:

– Maintain Competitiveness through Structural Reforms

– Fiscal Consolidation: Income Tax

– Reinforcement of security net

– Reduction in reliance on foreign deposits

– Resuscitate stagnant banking sector

Private Sector Credit

Bank Asset to Capital Ratio

Recommendations

Medium to Long-Term:

• Land Infrastructure

• Liberalisation of Energy Market

• Emphasis on Vocational and Higher Education

• Strengthening of Judicial system, especially liabilities

• Reducing the Grey Economy

• Reconsideration of tax system to improve inequality: Land, Consumption, Thresholds

Inequality and

Innovation

Government Finances

Government Debt (% GDP)

Budget Surplus 2012: -1.8%*

• Speculative Investment Bubble

• “Market Stability is Destabilizing”

• Stages:– Hedge Borrower: Cash Flows<=Debt-associated payments

Example: mortgages

– Speculative Borrower: Overconfident Euphoria Example: interest-only loan

– Ponzi Borrower: Excess Debt Accumulates Example: Negative Amortization Loan

– Debt Exceeds Repayment Capabilities – Minsky Moment

• Stood for better understanding of finance and of ending overreliance on mathematical models

Hyman Minsky Crisis Theory

Exports

• Account for 62% of GDP

• Increased 7 times between 2000-2012

• Exports: food, wood, chemicals, metals, services

• Unconventional Importers: Russia, Lithuania, Estonia, Germany, Poland

ImportsCloser Neighbouring States

Industrial Production

Trade/GDP = 118%

Balance of Payments

Aggregate Demand• AD sectors:

– Consumption (62%)

– Investment (23%)

– Government Spending (15%)

• Crisis:

– Consumption: -32%

– Investment: -76%

Foreign Direct Investment

Net

The End

Not Quite yet

Key Definitions

• Purchasing Power Parity: the sum value of all goods and services produced in a country valued in US dollars

• Human Development Index: a composite statistic of life expectancy, education, and income which is used to rank countries into four tiers of development

• High-technology exports: products with high R&D intensity, such as in aerospace, computers, pharmaceuticals, scientific instruments, and electrical machinery

Exchange Rates

• Nominal Exchange Rate (S) – price of domestic money in terms of foreign money

• Real Exchange Rate (𝜎) – the relative price of our goods and services in terms of foreign goods

𝜎 =𝑃

𝑃∗/𝑆

• NEER: Nominal Effective Exchange Rate

• REER: Real Effective Exchange Rate

Exchange Rates• Floating Exchange Rates• Fixed Exchange Rates:

– Positive:• Stable Trade – possibility of Union• Limited Speculation• High Fluctuation

– Negative:• Cannot perfectly adjust to inflation – Misalignment• Prone to crises• Inability to accommodate to external shocks → Internal Devaluation• Difficulty of Estimation

• Impossible Trilogy:1) Fixed Exchange Rates2) Full Capital Mobility3) Monetary Policy Independence

Peg Implementation

Short-term:

• Central Bank Interventions

Long-Term:

• Interest Rates

• Currency Controls

• IMF Special Drawing Rights

Very Long-term:

• Protectionism

• Supply-side reforms

• Dirty Float

Currency BlocsAdvantages:• Reduced Exchange Rate Costs

– Commissions and charges– Risk factors of currency fluctuations

• Greater Price Transparency– Comparison of prices– Lower price discrimination

• Greater Business Confidence– Stability promotes investment

• Macroeconomic ManagementDisadvantages:• Transition Costs• Less Monetary Independence

Gini Coefficient

• The principle measure of income inequality

• 𝐺𝑖𝑛𝑖 =𝐴𝑟𝑒𝑎(𝐴)

𝐴𝑟𝑒𝑎(𝐴+𝐵)

• Gini= 0 – perfect equality– Gini=1 – perfect inequality

• Example Values:– South Africa: 0.63– Sweden: 0.23– UK: 0.40– Latvia: 0.35

Balance of Payments

• Export of Goods• Import of Goods• Export of Services• Import of Services• Net Royalties• Net Investment Income• Net International Aid• Gross Inward Direct Investment• Gross Outward Direct Investment• Gross Inward Portfolio Investment• Gross Outward Portfolio

Investment• Short-Term Inward Capital Flows• Short-Term Outward Capital Flows• Errors and Omissions• Official Intervention Account

Trade Balance

Current Account Balance

Capital Account Balance

Current Account + Financial Account + Official Intervention=0

Balance of PaymentsExport of GoodsImport of Goods

Export of ServicesImport of Services

Net Investment Income/Royalties

Net International Aid/TransfersGross Inward Direct Investment

Gross Outward Direct InvestmentGross Inward Portfolio Investment

Gross Outward Portfolio InvestmentShort-Term Inward Capital Flows

Short-Term Outward Capital Flows

Errors and Omissions

Official Intervention Account

Trade Balance

Current Account Balance

Capital Account Balance

Current Account + Financial Account + Official Intervention=0

Deficit on the Current Account:

• Excess Supply of Currency

– Depreciation of Currency

– Restoration of Equilibrium

• Exports

• Asset Attractiveness

• Net Leakage of Demand

• Loss of Jobs

• Long-term Confidence

Competitiveness

1) Price Competitiveness:

• Relative Unit Labour Costs – labour cost per unit of output

2) Non-Price Competitiveness:

• Regulation:

• Environmental

• Employment

• Pensions

• Taxation

World Economic ForumGlobal

Competitiveness Index

Rating Agencies

Internal Devaluation

• Definition: pro-cyclical measure which occurs when a country attempts to improve competitiveness through lowering unit wage costs and increasing labour productivity, rather than through currency depreciation

• Latvia had no choice but to internally devalue due to Lat peg.

Maastricht Criteria(part of the “Treaty on European Union”, 1992)

• Fifth Stage of Integration: European Economic and Monetary Union

• Criteria:

1) Inflation: no more than 1.5% above average of Top-3 European economies

2) 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝐷𝑒𝑓𝑖𝑐𝑖𝑡

𝐺𝐷𝑃≤3% or converging to this value

3) 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝐷𝑒𝑏𝑡

𝐺𝐷𝑃≤ 60% or converging

4) Exchange Rate Mechanism Membership with two years stable peg

5) 10yr Government Bonds yields: no more than 2% above Top-3 European economies

• Surveillance Role– Article IV: Annual Visits and Evaluations– World Economic Outlook– Enhanced Surveillance– Macroeconomic Guidance– Statistical Innovations

• Lender of Last Resort: “the International Fire-fighter”– Duration of Loan: 1-4 years– Highest Priority– Types:

• Special Drawing Rights (SDR) – an allocated line of credit based on each country’s annual contributions

• Concessional Loans• Stand-by Arrangements

Founded: Bretton Woods (1945); 188 members; Centre: Washington DC

Directorship: Board of Governors, Board of Executive Directors

• SDRs are evaluated according to each country’s annual contributions, which are themselves based on GDP– £1 = SDR1.08

• Votes amongst the Executive Directors are distributed accordingly

Latvia 142 0.06%

Special Drawing Rights and Votes

Denominator Effect

NOW SERVING 50 EUROPEAN DESTINATIONS VIA RIGA

JURMALA: FROM GATWICK

MOSCOW: FROM GATWICK

Jurmala

Ssa SALE RIGA: FROM GATWICK

€85http://www.economist.com/blogs/charlemagne/2012/06/lessons-

latvia?zid=307&ah=5e80419d1bc9821ebe173f4f0f060a07

List of Useful Websites

• IMF• World Bank• CIA World Factbook• The New York Times

– Paul Krugman Blogs

• The Economist– Login: library@henleycol.ac.uk– Password: library

• BBC Business– Robert Peston– Linda Yueh

Quiz QuestionBalance of Payments

Trade Balance 67.6

Balance on Goods and Services 68.1

Net Investment Income/Royalties -35.4

Aid/Transfers -45.0

Direct Investment Abroad -228.6

Direct Investment Inward 146.1

Portfolio Investment Assets -258.3

Portfolio Investment Liabilities 290.1

Capital (Financial) Account -43.2

Other Investment Assets, eg Financial Derivatives -219.2

Other Investment Liabilities 226.5

Errors and Omissions ?

Official Intervention Account (Reserves) 16.9

Answer : -38.6