Baltic Economy Watch

Is The Risk Accompanying Estonia's Eurozone Membership Really So Low?

2011-08-14T08:56:00.006+02:00

"But the go-ahead Estonians are already scenting the next challenge. Should the single currency crumble, they are determined to be on the inside track for any new German-centred “super-euro”. Goodbye “eastern Europe”; welcome to the “new north”."
Edward Lucas, writing in The Economist

Estonia's economy put in another sterling performance in the second quarter of this year, even if the expansion rate fell back to quarterly 1.8%, down from 2.4% in Q1, and 2.5% in the last quarter of 2010. Well, you didn't expect the economy to keep growing at such strong rates for ever, did you? Evidently not. The interannual rate peaked at 8.5% in the first quarter, and dropped back slightly during the last three months to 8.4%, still this is no mean pace.

But given that the good things in life don't last forever, the real question now facing analysts and policymakers is not whether a fall of a tenth of a percentage point is significant, but rather the much more critical one of just how long the Estonian economic expansion can be kept going in the face a a more general European slowdown, given that the economy is now almost entirely dependent on export expansion for GDP growth?

Exports have been very strong so far this year. Although imports have more or less risen in lock-step.

Consequence, while the goods trade deficit has been substantially reduced, what remains stubbornly resists being eliminated.

Which draws attention to another feature of Estonian goods exports, a lot of them are processed products which are effectively re-exports of previously imported components, hence the value added component supplied by Estonian manufacturing is comparatively small. The share of value added in manufacturing (as a % of GDP) has risen sharply in recent quarters, from the earlier crisis lows, but at around 19.5% it is still up only about 1.5% on the pre-crisis levels. However, within this the share which is oriented to exports has undoubtedly risen.

Still, with value added in manufacturing under 20% of GDP, driving growth forward in the future is not going to be easy, especially now that a Europe-wide slowdown is gradually taking hold. And in a sign of what may now be to comme, exports fell sharply in June, to around 950 million Euros, from an average of 1.1 billion euros in the March to May period.

Indeed industrial output hit a local high in March, and has subsequently fallen back.

Retail sales are barely up from their sharp drop, and are unlikely to give much momentum to the economy in the months and years to come due to the substantial debt overhang which the household sector is still struggling with.

Likwise there is not much sign of a return to life in the construction sector outside government sponsored infrastructural activity.

Unemployment has fallen, but continues to remain high, and in fact the 7,000 drop between Q1 and Q2 is really quite small when seasonal factors and the fact exports were growing furiously are taken into account. It would thus not be surprising to see the numbers of unemployed once more rising going into the winter.

So the big question here is not whether Estonians worked hard to contain their fiscal deficit (which they obviously did), or whether they carried out some form of internal devaluation (they surely did). The key question is whether their internal devaluation went far enough, and whether the exchange rate with which the Estonians entered the Euro was not too high for their needs (a mistake the Germans made in the late 1990s, and which they subsequently paid for in quite costly fashion).

What does not seem to be generally understood in this whole "Estonia" debate is what the expression "export dependence" means. It doesn't simply mean that exports will play a significant part in forthcoming Estonian growth (I think that all parties are now agreed that this will be the case). It means that the level of household indebtedness coupled with the ageing population phenomenon means that domestic consumption driven growth is now a thing of the past, and what is worrying about the Estonian situation is the comparatively small size of Estonia's manufacturing industry.

New credit growth has all but disappeared in Estonia.

Something which is in many ways reminiscent of what happened in Germany following the unwinding of their 1990s consumption boom.

People are still waiting for the return of a housing boom in Germany (see mortgage chart below) but they will wait idly, demography virtually guarantees that, just as they will wait idly in Estonia for a return of the good old days, and meanwhile precious time is being lost.

Estonia's current account has now corrected:

Just as the German one did before it.

But Estonia still has some way to go before it realises CA surpluses on the scale which Germany does. And it still has even more way to go before it recovers the level of economic output attained before the onset of the crisis. Despite the strong recovery of the last year, Estonian GDP is still 10% down on its earlier peak.

Which is why it is worrying that Estonian inflation continues to run above the Euro Area average. This is not the way to improve competitiveness, and it is horribly reminiscent of the path which was trodden by peripheral economies to the West and the South after they joined the common currency. It doesn't really seem that too many lessons have been learnt here.

Strangely, as a country which has recently entered the common currency, country risk seems to have followed a path which is rather nearer to that of its Baltic peers than to that of equivalent Euro Area countries. Credit Default swaps on Estonia have fallen and remain down, whilst those of its East European Euro peers (Slovenia and Slovakia) have risen as one might expect as the crisis of confidence in the currency has grown.

Thus we find that a country which two years ago was being valued as having the third-riskiest sovereign debt in the European Union is now trading in quite another league, and finds itself included among the European "top ten" sovereigns in terms of price. Last week, while French CDS were hitting Euro era highs of around 160 bps, Estonian ones were sitting pretty at around 115. And just after S&Ps downgraded US sovereing debt, they upped the Estonian rating by two notches to AA-.

Their Valour Is Not In Doubt

"That he which hath no stomach to this fight,
Let him depart; his passport shall be made,
And crowns for convoy put into his purse;
We would not die in that man's company
That fears his fellowship to die with us".
William Shakespeare, Henry V, the Saint Chrispin's Day Speech

So the question I ask myself (as I did in this earlier post), is whether this kind of realignment in valuations makes any kind of economic sense? Of course positive comparisons with the United States and France are flattering, but am I the only one to see something funny going on here? Is contagion risk being reasonably priced in, is the risk of Euro Area break up being adequately priced, and if it isn't, do we not face the risk of a sudden (and hence destabilising) adjustment in the not too distant future?

Is there now nothing left to economic life but fiscal policy, or have we all collectively lost our sense of perspective? How can an economy which still shows the living scars of its earlier sharp distortions be so highly rated?

Obviously, it is clear that the Estonian Sovereign was never, even during the worst moments of the financial crisis, and under the most severe of worst case scenarios, the third riskiest to be found within the frontiers of the EU (Estonia was the only EU country to have a budget surplus last year - worth 0.1 percent of GDP - while public debt totaled a mere 6.6 percent). On the other hand it is the case that Estonia faced an extremely challenging crisis in 2008/09, and had the Euro peg collapsed in one of the four East European countries who had one at the time then the pressure of private debt could certainly have confronted the country with some very complex and difficult choices.

But Their Wisdom, And Sense Of Foresight.........

Following the argument along a bit, it is far from clear that the current level of Estonian CDS prices risk in in any more satisfactory way than it did at the height of the crisis, since membership of the Eurozone has brought with it both positives and negatives. The 0.28% contribution of the country to any future EFSF bailouts may not seem like a very big deal, but in comparison to Estonian GDP the sums involved may well be far from trivial. The country does not have, and is not likely to have, either a fiscal deficit or a sovereign debt problem, nor does it have a home grown banking system which might need bailing out. The risk to Estonia comes from elsewhere, from its association with Ireland, Spain, Greece, Portugal and Italy. Depending on how far the core EU countries are willing to finance debt and absence of growth in those countries the Eurozone's future is far from clear. If, as Edward Lucas speculates, a division to go with the strong currency German lead component which could be created in the case of break-up, Estonia's leaders may live to rue the day they missed the opportunity to make a substantial devaluation in the currency before entering the Eurozone.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Smoke On The East European Horizon?

2011-07-10T21:56:00.001+02:00

"The market is pricing these sovereigns at much wider levels than where their agency ratings would imply," said Diana Allmendinger, a director at Fitch Solutions.CDS on Italy imply a rating of BBB, five notches below its agency rating of AA-minus. And Spain's implied rating is BB-plus, nine notches below its agency rating of AA-plus.

With so much emphasis being placed on what has been happening farther to the South, economic realities on Europe's Eastern periphery have largely been escaping the close scrutiny of media and analyst attention. In the wake of the belated recognition of the region's vulnerability which followed the bout of acute stress experienced during the post-Lehman crisis, a new consensus has now emerged (for an in-depth study of the Latvian example see this piece) that the IMF-guided programmes put in place at the time have essentially set things, if not entirely straight then at least on the right track. In particular, as a result of the extensive fiscal discipline and willingness to sacrifice shown a much brighter future now awaits these countries well to the sidelines of all those horrible Greek debt concerns.

Certainly this is the picture you get from looking at the way the ratings agencies have been treating many of the countries in the region. Only last week Fitch upgraded Estonia to A+, citing the country's solid economic growth performance, exceptionally strong public finances, declining external debt ratios and increasing stabilization in the banking sector. But since many reservations have been being expressed in Europe of late about the validity of rating assessments, I thought it might be interesting to seek out an alternative opinion, and take a look at what the financial markets have been saying, at least as far as the recent evolution of Credit Default Swap prices go.

The recently upgraded Estonia, for example, was being valued as recently as just two years agao as having the third-riskiest sovereign debt in the European Union. But the country is now trading in quite another league, and finds itself included among the European "top ten" sovereigns in terms of price. As reported by Bloomberg on 20 June, Estonian credit-default swaps were trading at 87 basis points, while France was being quoted at 83.7, the Czech Republic at 83, Austria at 68.7 and the U.K. at 66, according to data provided by CMA. By way of comparison Polish CDS stood at 159.6. Effectively, Poland was being considered as almost twice as risky as Estonia. The big question, of course, is whether this kind of realignment in valuations make any kind of economic sense? Is contagion risk being reasonably priced in, and if it isn't, do we face the risk of a sudden (and destabilising) adjustment in the not too distant future?

Obviously, it is clear that the Estonian Sovereign was never, even during the worst moments of the financial crisis, and under the most severe of worst case scenarios, the third riskiest that was to be found within the frontiers of the EU (Estonia was the only EU country to have a budget surplus last year - worth 0.1 percent of GDP - while public debt totaled a mere 6.6 percent). On the other hand it is the case that Estonia faced an extremely challenging crisis in 2008/09, and had the Euro peg collapsed in one of the four East European countries who had one at the time then the pressure of private debt could certainly have confronted the country with some very complex and difficult choices. So, if we all stop being emotional about CDS for a moment, and start to consider that they might be a traded instrument which can tell us not who is about to default but rather something about the perceived levels of country risk at a given moment in time then they might offer us some sort of yardstick for following how market sentiment is moving, and even (the case in point for my argument here) whether market pricing of relative risks is in line with economic fundamentals.

So, following the argument along a bit, it is far from clear that the current level of Estonian CDS prices risk in in any more satisfactory way than they did at the height of the crisis, since as we will see there are rather curious anomalies in the way in which some of the countries in the region are being priced, while an excessive short term emphasis on fiscal deficits has perhaps mislead observers about real risks in Europe whether these lie to the South (Italy) or to the East.

It is not my intention here to single out Estonia for special - negative - treatment (that would not be warranted) but the value being placed on the CDS really is incredibly low for a country that just entered a Euro Area whose outlook could, at the very least, be considered as reasonably uncertain. It is being priced as part of core Europe, when in reality it forms part of Europe's periphery. Arguably, were the Euro to break in two, Estonia would incline towards riding with the German lead group, but given the fact that the country now has a totally export dependent economy (this is the part that I feel is least understood) , and a currency which was arguably over valued at the time of Euro entry (and the country now has ongoing above-Eurozone-average inflation) it is not clear how prepared the country would be to handle the challenges of being attached to the new, and ultra-high value, currency which would be created. Of course, some are going to argue that the risk of this happening is slim, but is this risk, small as it may be, currently being priced in? That is the question. I suggest it isn't, and this creates the possibility of a dangerous surprise in the markets in the event of a disorderly Greek default.

Strangely, as a country which has recently entered the common currency, country risk seems to have followed a path which is rather nearer to that of its Baltic peers that equivalent Euro Area countries.

This disparity becomes even more striking if we look at the evolution of Baltic CDS with those of the two countries in Eastern Europe who entered the Eurozone before Estonia. The spread on Slovenian and Slovakian CDS has surged in recent months, not because short term risk of sovereign default in either of these two countries has increased notably, but simply because these two countries as members of a Eurozone with known problems, and real contagion dangers, are now seen as being more risky. So why isn't this the case with Estonia?

True Slovenian and Slovakian CDS are still comparatively low risk priced (Slovenia at 109 and Slovakia at 102) but it is the direction and velocity of the movement which is striking, and especially in comparison with Euro Area peer Estonia. Why are these two countries considered to be more at risk than Estonia, especially given the size of the latter's recent historic legacy?

Moving beyond the Baltics, risk in a number of other East European countries seems quite mispriced, unless we think that only being pegged to the Euro (rather than actually being a member of it) is a less risky mode to live in. Bulgarian CDS (currently around 225) have been steadily moving down all this year, and in sharp contrast to what happened in June last year, have so far not responded to the Greek crisis, despite the fact that Bulgaria's banks are quite dependent on their Greek parents for funding.

The picture in Romania is rather similar, with the current price of 250 being well off last years highs of around 415, which means that markets are currently perceiving risk in Spain and Italy as more pronounced than those in Bulgaria and Romania. Certainly I would not want to argue that risk in both the aforementioned countries is high, but I am not at all convinced that contagion risk in the latter two is anything like as low as is being suggested, which is presumably why Nomura was recently advising clients in a research note to sell South African CDS and buy the wrongly priced Bulgarian and Romanian ones (also see here). Looking at the macro economic fundamentals of the respective cases, I can't help feeling that in this case the analysts are right.

And if we move over to Hungary, then we find that as of last Friday CDS stood at around 285, well below the highs of over 400 seen as recently as last November in the wake of the Irish crisis.

Arguably the Hungarian case is the most glaring one, since it is the East European country with the highest debt to GDP levels (around 80%) it has very high gross foreign debt (around 135% of GDP, of which 45% is forex denominated), and it is a country where institutional quality is a constant cause for concern. In many ways Hungary is the Italy of the East. Apart from the presence of a strong trade surplus there is not that much to commend in Hungary's recent economic performance, yet its CDS has fallen into line with a regional pattern, and there is little in the way of what is happening in Spain and Italy to be seen in the spread, let alone what is going on in Slovenia and Slovakia.

Both Hungary and Romania were the object of IMF/EU rescues during the height of the financial crisis, and as a result their financing problems subsided. Both countries have made substantial progress in reducing their fiscal deficits, and have carried out a number of structural reforms. But both countries still have high levels of external indebtedness coupled with economies which are now extraordinarily export dependent for growth. In addition the demographic outlook for many of these countries is absolutely dire, and you will continually have smaller and older workforces trying to pay down increasing quantities of debt.

This underlying reality constitutes an unstable combination which make the countries concerned highly vulnerable to both a renewed deterioration in sentiment and an external economic slowdown of the sort we could see following a disorderly Greek default, and yet markets in general seems to be shrugging off the risk as almost non existent. "Smoke on the horizon" the admiral said as he lowered the telescope from his blind eye, "I see no smoke on the horizon".

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

BELLS In Hell That Don't Go Ting a Ling a Ling

2011-06-02T20:18:00.001+02:00

After the BRICS, came the PIGS. Now a new acronym is being born, that of the BELLS. These particular "ding-dongs", however, are not a set of hollow cast-metal instruments suspended from the vertex and rung by the strokes of a clapper, they are countries, countries which may, like those unfortunate WWI British soldiers whose love of their country and sense of duty lured them into one of the most senseless conflicts of modern European history, be headed towards their own pretty unique form of modern purgatory.

The BELLS are a group of four countries (Bulgaria, Estonia, Latvia and Lithuania) who in their wisdom decided to adopt and then stick "come hell or high water" to a currency peg with to Euro. Thus was opened one of the more interesting and lively chapters in modern macroeconomic debate.

Now talk of some sort of ultimate inferno here may strike a pretty discordant note with many readers, since most of the economic chatter of recent days has centred on how the BELLS constitute a positive example, not to mention a most attractive alternative to all those dreadful sounding PIGS. According to GaveKal's François-Xavier Chauchat, for example, the BELLS should be seen as a ray of "Hope For EMU Peripherals", since just like the PIGS the BELLS have also had their own debt crisis, one which was so severe at the time that it put into question the very sustainability of their fixed exchange rate regimes. However, in these most fortunate of cases, the bad times are now well and truly behind us since a happy combination of IMF programmes and fiscal consolidation (coupled in Estonia's case with subsequent admission into the Euro group) eventually led them out of crisis, and without the need for any sort of sordid devaluation to boot. And then, as they say in Spanish "fueron felices y comieron perdices" (or to put it the English way, "they all lived happily ever after"). Or did they?

Well, on Chauchat's view, the BELL crisis was always more of a liquidity than a solvency one (see chart below) – and this despite the fact, which he notes, that Latvia was very often argued to be a modern equivalent of the Argentina of the late 1990s (an assertion which, he says, has ultimately proved to be wrong, although in fact on this particular solvency vs liquidity argument, the true test will be the ability of Latvia to pay back the 7.5 billion euro EU/IMF bailout loan, in full and on time, and especially the very onerous 2014/15 installments). From a macroeconomic perspective, however, the big issue was always one of just how the hell these countries were going to dig themselves out of the hole they had dug themselves into, and do so at the same time as staying on the peg.

A Profession That Is Losing Its Grip On Reality?

The view that the BELLS have somehow proved the monstrous regiment of professional macroeconomists totally wrong is now quite widespread (for a balanced and more nuanced version of the argument see this post by my fellow RGE Economonitor blogger Ed Dolan) , and indeed such sentiment may well form part of a much more general dispute between micro- and macroeconomists about how to find solutions to the present crisis. Only last week the Latvian Prime Minister Valdis Dombrovskis presented a book in Riga which he has co-authored with Anders Åslund of the Peterson Institute which has the rather assertive title: How Latvia Came through the Financial Crisis. The associated press release proudly states that a key lesson to be learnt from the resolution of Latvia’s financial crisis is that "devaluation is neither the panacea nor the necessity that many economists make it out to be".

Not content with this statement our authors go even further, striking what some might consider to be a rather too "close up and personal" tone:

"Finally, the international macroeconomic discussion was not useful but even harmful. Whenever a crisis erupts anywhere in the world, a choir of famous international economists proclaim that it is “exactly” like some other recent crisis—the worse the crisis, the more popular the parallel. Soon, prominent economists led by New York Times columnist Paul Krugman claimed that “Latvia is the new Argentina.” A fundamental problem is their reliance on a brief list of “stylized facts,” never bothering to find out the facts".

As a macroeconomist who has been deeply involved in the Latvian debate I have to say that if such statements weren't so foolish (and ill-befitting of the Prime Minister of any country) I would want to protest that they were extraordinarily condescending and even verging on being insulting. As someone who has spent hours and hours during this crisis perusing excel sheets and making charts trying to fathom what is going on in the BELLS (and in particular in Latvia) I have to say I certainly don't recognise myself in this paragraph, and if anyone could be bothered to take a look at that infamous Krugman piece they would find he was basing his argument not on some obscure set of stylised facts, but on my detailed analysis of the problem (right or wrong, but here it is - why the imf's decision to agree a Latvian bailout programme without devaluation is a mistake).

The funny thing is that, far from having learnt from the error of my ways, I still consider the original IMF decision to have been a mistake, although I would point out that I personally never suggested Latvia was like Argentina (another thing is to say that much of what is going on along Europe's periphery of late carries with it a distinct sense of Argentina deja vu), since I actually think that Argentina is an example of what not to do and that if you are looking for historical precedent for what should be going on in Latvia (read the BELLS) Turkey would be a much better role model. I also think that one of the conclusions we will eventually be able to draw from this whole sorry affair is that those who specialism is not macroeconomics would do better dedicating more of their precious time to trying to understand what we are saying rather than engaging in ill-informed ideological polemic. And I say this since I believe that the Latvians themselves deserve better. They may well not be able to avoid serving as guinea pigs, enabling macro- and microeconomists to see just who is right, but they surely don't merit being converted into yet another ideological football. Didn't we have enough of that during the Soviet years!

On the other hand, and before getting into the actual analysis, I want to stress that I personally am not advocating devaluation of the Lat at this point in time. Even though I still consider it a mistake not to have devalued, and an even bigger mistake on the part of the EU leadership not to have accepted the IMF proposal for immediate devaluation and Euro entry, I accept that the decision not to devalue represented the democratic will of the Latvian people (following the advice of the IMF given the EU response), and it was for precisely this reason that I declined to go to Latvian in August 2009 and speak at a meeting organised by the then governing People's Party, since I think I was only being asked to go there to cause trouble.

The difficult thing here is not to cause trouble (which is easy) but to find realistic solutions, which is why we need free and open debate.

Did Latvia's Internal Devaluation Cut Hard Enough And Deep Enough?

The point, I think, is this: if Latvia is not going to recover the competitiveness all agree it lost through a normal devaluation process (for whatever reason) then it needs to do so via the procedure which has become known as "internal devaluation" (a procedure which in an earlier era was known by the name of "wage and price deflation"), and indeed this is what the Latvians have attempted to do.

So the question now is has this worked? Or put another way, has the internal devaluation gone far enough and deep enough? The conventional wisdom has it that it has, but I, for one, am not convinced, and looking at the latest round of Latvian data serious questions arise as to whether the recovery is strong enough or sustainable in the longer term.

Growth started to return to these economies in the second half of 2010, but with capital inflows now well below pre-crisis levels they have now entered a lengthy and difficult adjustment process. With domestic demand well below earlier highs and still struggling, exports have now become the prime mover of economic growth. Since the recovery in external demand has produced a rapid return to earlier export peaks the impression of a return to earlier economic dynamism has been created. I think this interpretation of the recent strong export growth is misleading, since it is one thing to recover lost ground, and quite another to attract the FDI needed to seriously expand capacity and keep increasing exports beyond their pre crisis peak. Strong year-on-year increases in exports have moved headline GDP numbers forward, but as 2011 continues annual export growth rates will drop substantially, and may even get stuck at a snail’s pace, meaning that the respective economies will be struggling to find growth, create jobs, and maintain the servicing of their external debt.

The most worrying piece of evidence I have found is the failure of capital investment to rebound alongside exports. In part this is understandable, since a lot of the earlier capital investment was in property, but this offers only part of the explanation, since for these economies to really take off as export driven strong new investment growth in plant and equipment will be needed. In order for these economies to attract investment in sufficient volume they will need to recover a large part of the competitiveness lost between 2005 and 2008, when wage growth far outpaced productivity gains. However, given the difficulties faced in lowering the exchange rate, they can only realistically try to recover lost ground through sustained productivity improvements, a lengthy and slow process, and in the meantime the debt and population ageing problems keep ticking away

In my opinion, and despite some early encouraging signs, it is far from self-evident that the so called “BELLS” (Bulgaria, Estonia, Latvia and Lithuania) are going to be able to export their way out of trouble in the way they need to (given the collapse of internal demand) with the current relative price structure. It is my considered opinion that the “internal devaluation” process may have been underambitious and allowed to come to a halt far too soon. And indeed, if we get to the point, this is why so much of the conventional macroeconomic wisdom and advice leans towards open devaluation, simply because it is hard to maintain the political consensus for long enough to carry out a deep and painful deflation adjustment, and indeed this is the lesson drawn from the 1930s that I was brought up on.

Export Dependency and An Ageing Workforce

In addition two major unresolved issues may leave a legacy, one which could weigh down any recovery and lead to more serious problems when the next recession eventually arrives. Many observers seem to forget that it is one thing navigating a leaky ship when you have the wind behind you, and quite another one going face-forward into a tempest.

In particular there are two things which preoccupy me about the present situation:

a) The existence of a substantial debt overhang the credit crunch which exists as a result
b) The demographic challenges the country faces, and in particular the impact of a rapidly ageing and declining population.

But before getting into this, let's take a serious look at the current state of play in the Latvian game.

Worrying Signs In Latvia

The first thing I notice when I start to go through the Latvian data is that despite a substantial improvement in exports:

GDP growth is currently slowing.

Latvian GDP expanded by a quarterly 1.5% in Q3 2010, by 0.9% in Q4 and by 0.2% in Q1 2011. Thus Latvian GDP has been steadily slowing, and this despite the fact that the export environment in the first three months of this year was exceptionally positive, and Latvian exports were booming. Latvian GDP fell by around 25% during the crisis, and has subsequently rebounded by 5% (over 5 quarters). We are far from a "V" shaped recovery, and pardon me if I mention it, but it is precisely the sort of thing most macroeconomists were imagining would happen.

Essentially the problem is that consumer demand has failed to recover, and if my analysis (about ageing and the debt overhang) is right then it will continue to fail to recover (all of this, incidentally, is what I argued would happen after the crisis broke out).

Industrial output languishes (partly because the non-tradeable sector is contracting as fast as the tradeable one is expanding).

While capital investment fails to recover:

Obviously a large part of the investment slump is due to the decline in consumption activity, but there is little sign of a serious pick-up in ex-construction investment, and anyway, outside of construction there was comparatively little investment going on in the period before the bust, and very little FDI.

So Where Is The Problem?

Basically the Latvian economy faces three main problems

i) a debt overhang
ii) a declining and ageing population
iii) a high level of unemployment, low rate of job creation, and a substantial wage differential with Western Europe which encourages young people to emigrate and drift west.

The first two problems put a serious brake on economic growth, and it is this that exacerbates the third problem, which then in its turn feeds back and aggravates the first two.

Cheap interest rates, supported by the peg and the prospect of Euro membership meant that Latvian households and corporates were able to get themselves heavily into debt. And debt in Euros (which is why the devaluation difficulty exists) - over 85% of Latvian mortgages are Euro denominated.

Now the Latvian economy is experiencing a sharp credit crunch, private sector credit which was increasing in 2007 at a rate of around 65% is now falling at a rate of 9% per annum.

Has The "Internal Devaluation" Been Called To A Halt Too Soon?

Claims that Latvia's internal devaluation has been deep and effective are widespread.The following claim from Commerzbank's Barbara Nestor is typical:

"The competitiveness adjustment has been substantial; labour costs fell 25% from the peak. The gap that opened up between productivity growth and labour costs in the boom years has already been closed. Exports responded sharply. Resources have not been switched among sectors, but production has been redirected from domestic use to exports".

The IMF itself is also pretty congratulatory. In this months press release announcing completition of the fourth review of the standby arrangement they state:

"Strong policy actions under the SBA have helped restore confidence, contributed to economic recovery, and enabled significant progress toward Latvia’s goal of euro adoption. The government has continued to achieve substantial fiscal savings while also protecting the poorest through social safety net spending and a temporary public works jobs program, and is strengthening its active labor market policy efforts. Looking ahead, the government has committed to meet the Maastricht criteria for euro adoption and strengthen the financial sector, which should further enhance confidence and support a rebound in growth".

Or again in the joint IMF/EC Statement on Latvia on the Review Mission:

The Latvian economy is now showing clear signs of recovery, with economic growth of 3.3 percent expected this year, reflecting the Latvian authorities’ continued implementation of their economic program. Their policy agenda for 2011 sets the stage for meeting the conditions for euro adoption in January 2014, and for sustaining the economic recovery

But is the Latvian economy showing clear and unequivocal signs of recovery? This is exactly the question I am asking here. Part of the issue is whether the competitiveness correction has so far been deep enough to ensure a higher level of competitiveness in the non-tradeable sectorer and a shift of resources from non-tradeable to tradeable. Certainly when the IMF programme was being contemplated, the extent of the correction needed and the difficult challenge which implementing it would involve was not doubted by anyone. Here's what the IMF had to say at the time of the staff report on the standby facility request (IMF emphasis):

In addition to maintaining the existing fixed (narrow-band) exchange rate, staff considered a number of alternative exchange rate options. These included, inter alia: (i) widening the current exchange rate bands to the full 15 percent range permitted under ERM2; and (ii) accelerated euro adoption at a depreciated exchange rate.

The main advantage of widening the bands is that it should eventually deliver a faster economic recovery. Although growth would be depressed in the short run by balance sheet effects, the economy might then bounce back more sharply, and a Vshaped recovery would likely start in 2010. This reflects a faster improvement in competitiveness since high pass-through (reflecting Latvia’s openness to trade and liberalized movement of labor within the European Union) would be dampened by the negative output gap. Enhanced competitiveness would also reduce the current account deficit more quickly. This would come mainly from import compression, with a relatively slow response of Latvia’s underdeveloped export sector, especially as the external environment is not as supportive as in previous devaluation-induced recoveries as Argentina, Russia or East Asia.

So at the time a 15% exchange rate adjustment was being contemplated. Did we get that? Well I personally don't think so. If we look at the CPI, the drop (from peak to trough) is only something like 3%.

In fact the producer price index fell a little further, maybe by about 12%.

But as can be seen, in both the CPI and the PPI case, since these indexes bottomed prices are now rising again. And indeed they are rising faster than is the case in those countries with which the Latvian currency is pegged (the Eurozone 17).

So in fact, and especially if we take as a point of reference the start of 2007, we can see that the actual price correction has been comparatively small, and indeed the position is once more deteriorating, even though output in the Latvian economy is over 20% below its pre-crisis peak. Is that really such a flexible situation?

A similar pattern emerges if we look at wage costs and productivity.

As we can see, despite having a relatively high standard of living Germany has managed to maintain unit labour costs relatively stationary over the last decade, due to rising productivity. Latvia evidently has not. This has nothing to do with being rich or poor, as can be seen from the years 2000 to 2004 Latvian living standards were rising, but they were rising in line with productivity, which is of course perfectly sustainable, and basically the pattern you want to see. Then from 2005 onwards the link was broken, and Latvian wages exploded in a way which was totally unsustainable. During 2008 and 2009 unit labour costs started to improve (in part because a lot of very unproductive workers in construction lost their jobs, the pattern in Spain is similar) but from the start of 2010 onwards the process has been in reverse gear again, and once more it is interesting to note that German labour costs (even though the economy is booming) are not following suit.

A lot of ink has been spilt writing about the large drop in wages in the public sector (possibly over 20%) but unfortunately public sector workers normally don't export, and if we come to look at private sector wages, and especially hourly wage rates, then we again find that the correction has not exactly been massive, and of course, inter-annual wage rates are once more starting to rise.

The rough and ready measure most macroeconomists like to use when it comes to competitiveness changes if the Real Effective Exchange Rate, and as we can see from the chart below, the loss of competitiveness (when compared in this case with Finland) since 2005 has been substantial. But then when we use REERs most people who really aren't that convinced that exchange rates matter tend to be not very impressed.

So let's try and put the argument another way. The real proof of the pudding is in the eating, and the real test of Latvian competitiveness is whether, now that it is totally export dependent, the Latvian economy will be able to produce sufficient economic growth and employment such that the weight of the debt can be steadily burnt down. And let us remember here the currency pegger's (or euro member's) catch 22: growth in nominal GDP is what matters when it comes to reducing debt, and nominal GDP is composed of real growth and inflation, so in a way inflation could be beneficial, but any inflation you have which is over the level of your countries of reference (the Euro Area 17) will lose you competitiveness in a way which reduces real growth, so you are up against a limit on both sides (deflation, which makes you more competitive, only compounds the debt problem) and possible the most appropriate characterisation of the situation would be "trapped".

The real problem now is that the credit-bust economies are totally export dependent for growth. What does this mean. Well let's take this simple and rough-and-ready expression:

GDP = Domestic Consumption + Investment + Government Spending + Net Trade

(Growth in Net Trade = Growth In Exports – Growth in Imports)

Which means growth in GDP = Growth in the sum of the above factors. Now we know that domestic consumption is in decline, and that investment in plant and equipment will only return in statistically interesting volumes to meet the needs of export growth. We also know that government spending is being reduced (that is what the IMF programme is centered on), so all we are left with for a real growth driver is exports.

But when we come to look at the SIZE of the Latvian export sector, we will see it is way to small for the job. The chart below comes from national accounts published by the Latvian statistics office, it shows GDP and value added in manufacturing industry. I think it is obvious that the proportion here is horribly small (only slightly over 10%), since even though Baltic economies generally are fairly open, many of the exports are in fact imports that have been reprocessed so actual proportion of their value produced in the country is not large. Germany by comparison (which is a modern economy, with reasonable living standards) has over 40% of GDP originating in value added in manufacturing. Yet this tiny part of the Latvian economy is now about to do the heavy lifting? It just doesn't make sense. Nor does it make sense that the IMF focus so much attention on reducing the fiscal deficit and virtually none on this issue, yet it is on resolving this issue that Latvia's economic future belongs.

There is another piece of evidence that Latvia's internal devaluation has eased up far to soon, and this comes from the current account. A great deal of praise was lauded on Latvia for the rapidity with which the current account went into surplus. In part this was the "ouch" effect, as financing dried up, people lost their jobs, and imports fell sharply. Exports, as we have seen, also improved, and this certainly helped. But there was another factor which we should also take into account, and that was what happened to the income account. This is composed of interest payments and returned profits and dividends. Now Latvia has a net external debt of not far short of 100% of GDP, and this involves a lot of interest payment. As is well known, most of this debt is denominated in Euros, and attached to Euribor interest rates, so of course, as the ECB brought rates down, interest payments came down in like fashion. At the same time, as the economy was contracting by 25% firms were producing a lot less in the way of profits, and there were far fewer dividends.

Now things are improving again, and as we can see in the chart below, the current account is once more moving back towards deficit. This is not a good sign.

So there we are, these are my causes of concern, and I think it is now over to those who already feel that the devaluation debate has been shown to be irrelevant to suggest what they think should be done next to put Latvia back on the "internal devaluation" track again. When I suggested at the start of this post that Latvia might be stuck in a peculiar kind of hell, possibly limbo would be a better term. Latvia's current situation is hardly comfortable. Unemployment is still very high, and new employment is only arriving in a trickle. Meantime the debts are still there, and the problems people are having paying them haven't gone away. In this sense a "restructuring bomb" is still ticking away under Latvia, and rather than continually crying victory maybe it would be better if more people (Prime Ministers included) dedicated a little more of their energy to trying to defuse it.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

And Then There Were Seventeen....

2011-01-09T21:21:00.000+01:00

"If you know your Thucydides and the Melian dialogue you know that small countries rely most on everyone following the rules. That's why we follow the rules. If there are no rules, then the big will do what they want,"
Estonian President Toomas Ilves in an interview with the EUobserver

In a blog post which has gathered a certain notoriety, Paul Krugman recently sent the Estonians his condolences. I will send them, not my condolences, but my congratulations, and these not for the somewhat dubious honour of being allowed to join the Eurozone, or even for having carried out a highly successful "internal devaluation" (this outcome is still in doubt), but rather for their stubborness, courage and tenacity. These are indeed hard (and enduring) men and women. And in honour of their courage I offer them a homage, in the form of two charts. The first of these is the latest Estonian industrial production one.

While the second is the Spanish equivalent.

Can you spot the difference? If not squint a little closer. Estonia's economy fell by around 18% during the crisis, while Spain's has so far has fallen only by something like 7%, yet Estonia's industrial output is now almost back to where it was before the crisis started, while Spain's has fallen but so far not recovered. No sign of even the tiniest green shoot.

Curiously, Spain's political leaders constantly complain that the markets are being unfair to their country, and are underestimating their ability and determination in responding to the crisis, yet if we compare the relative performances of the industrial sectors in the two countries, it is pretty obvious why the markets entertain the doubts they do. Both are destined now to live from exports, but one country is evidently living rather better from them than the other. It is clear that companies in the Estonian industrial sector have been far more agile in diversifing and finding new markets than have their Spanish counterparts.

Both countries experienced a construction lead "boom-bust" (Spain's of rather larger proportions than the Estonian one), and consequently now face highly impaired domestic demand, yet the Estonians have succeeded where the Spaniards have failed, by shifting a part of their previously inwardlooking industrial base towards the outside world and towards growth. There is simply no other explanation for the evident discrepancy, since (as we will see below) Estonia's industry is not growing due to the pull of domestic demand, although it is on the point of returning to "back to normal" operating levels. Spain's export sector is also recovering (after all the external demand is now there), but the part of Spain's industry which is geared towards supplying domestic demand simply hasn't been able to adapt, and is still contracting along with domestic consumption. In fact it is still contracting so rapidly that that the shrinkage is totally cancelling out all the fine work being done by the companies who are doing all the exporting, which is why industrial output remains more or less stationary, and the Spanish economy fails to return to life.

Many Rivers Left To Cross

Well that, as they say, was the good news. What follows possibly won't be anything like so palatable for Estonians to read as what went before, which doesn't mean it isn't worth reading and thinking about. You see, that old black magic (sorry, devaluation) debate, was never about whether or not the Estonian export sector could recover to its old level after the economic contraction came to a halt. As I keep stressing, it is obvious that it could, since in this case recovery depends on factors external to Estonia, and these factors have now changed, as a number of countries have seriously started to recover. No, the issue was always about the fact that the Estonian economy had become severely distorted during the boom years, and that the existing export sector was too small to do the heavy lifting that was going to be required of it after the bust in domestic demand. How many times did people say to me during those early days "but what can we export?", or "don't you realise that Estonian exports are largely re-exports of processed imported goods", as if these added disadvantages made the situation any easier, or my arguments somehow irrelevant. When a country is in trouble, but really in trouble, one of the first signs, I reckon, of the depth of the problem is that you get a long queue of official economists lining up to give you a thousand and one reasons why it is going to be impossible to export your way out of difficulty. This is like a leading indicator for "problems looming", since the situation has become so serious that effective solutions are virtually beyond the realm of the thinkable, and we need to soothe ourselves with nice sounding palliatives. In the realm of economic science, however, reality has a nasty habit of coming back and waking us from our slumbers.

What all this really suggests to me is that the thrust of the original argument about why the size of the export sector needs to increase sharply in economnies which have become so badly distorted as the Estonian and Spanish ones have was never really properly understood. So it is in honour of all those valiant Estonians who have sacrificed so much in order to gain so little that I endeavor just one more time to make things clear (my original pieces on Estonia's internal devaluation can be found here and here).

The Estonian Economy Is Recovering!

As one-commentator-after-another never tires of informing us, the Estonian economy has returned to some sort of growth recently, indeed (hat tip to Krugman) the Washington Post even went so far as to lump it together with Germany as one of Europe's “growing economies”, while the Economist Central Europe correspondent described it as a Nordic Kitten, seemingly a designation created to distance it from its more problematic Baltic neighbours. Unfortunately, wine doesn't improve simply by changing the label on the bottle (even if it does now say “appellation Frankfurt controlé”), and Estonia is neither a growth economy (which is the Goldman Sachs term for the new Emerging Market tigers like India, Indonesia, Turkey and Brazil) nor is it a "growing one", it is simply a "steadily recovering" one, and what's more, given the severity of the challenges it still faces it is far from having entirely managed to distance itself from the set of economic problems characteristic of what has come to be known as the “Baltic syndrome”.

Yes, Estonia’s economy has now started to grow again, indeed it was up by an annual 5% in the third quarter. But, to put this number in context, it was still down by around 16% from the Q4 2007 high, and just below the level of Q3 2005. So there is still rather a long way to go to get back to meaningful growth, indeed so long, as Krugman again points out, that IMF forecasts don't contemplate the country's economy reaching its 2007 level again before 2015 (Germany just more-or-less hit its 2007 level in 2010).

So, what is slowing the recovery down? Well, as I indicated at the start of this post, it certainly isn't the industries in the country's export sector, which are now more or less back to where they were before the crisis started.

But rather the problem lies in the state of private domestic demand, which obviously isn’t recovering.

As the Estonian Central Bank put it in their economicpolicy statements (and here, and here) on the latest GDP numbers:

“Estonia's recovery has been mostly driven by exports, which, measured in current prices, reached close to the all-time high in September”, and “Export growth indicates that the economic activity of our main export partners is expanding quickly and Estonia's companies are making good use of it.... The export volume of industrial production reached a historical high in the third quarter. Irrespective of the continuously weak domestic demand, the sale of industrial production started to pick up in the domestic market as well, but it is still some 25% below the pre-crisis level.... since unemployment continues to be high, the level of consumers' income and purchasing power will remain weak in the next years”.

And as the central bank also point out, export growth will now be harder (that is we have now picked most of the low lying fruit).

“Though most of industrial enterprises still have under-utilised production capacity, the existing capacity stock is running out along with rapidly expanding sales volumes. This refers to the need for additional investment”.

Yet, unfortunately, the sad truth is that investment activity has still not picked up.

This lack of series investment in fixed capital contrasts sharply with recent movements on the equities side, since, according to Bloomberg data, Estonian stocks are valued at an average of 16 times estimated earnings, compared with 11.3 times for Polish and Czech shares, and 12.6 times for Slovenia (the chart sort of resembles the export one, doesn't it?).

But the issue is this: following a pattern seen in many emerging markets over the last 12 months, short-term fund inflows pushed values on the Tallinn exchange up by some 73% in 2010, making it the third-best performance worldwide, according to Bloomberg data. They also quote Tallinn-based SEB researcher Peeter Koppel as saying: “Euro adoption has somehow triggered more widespread thinking about saving and investing in general,”...... Foreign retail investors “now have the hard fact of euro and the certain caution, especially from the Scandinavian side, is gone.” Which sounds to me more like “previously wary investors have now thrown caution to the wind,” on the back of all the pro-Euro Nordic-kitten hype. What Estonia needs, and is not getting (as the central bank itself recognises) is serious, long term, FDI for greenfield projects generating jobs and output in the export sector.

Boosting Domestic Demand Means Increasing The Size of the Export Sector & Creating Employment

As I say, in contrast to what is happening in the external sector domestic demand is far from recovering. Retail sales were up 5% (at constant prices) in November over November 2009, and 1% in October. But the annual rise is more a by-product of the very low level of sales hit in November last year, and in fact between January and November 2010, retail sales were down 4% compared to the same period in 2009.

The domestic construction sector isn’t recovering either. According to Statistics Estonia, the total production of Estonian construction enterprises increased 1.2% in Q3 2010 compared with a year earlier. But when you read the fine print, the increase was entirely produced by construction companies operating abroad (whose activity was up by 25%) – ie once more it is a question of exports.

And in fact construction output inside Estonia fell by around 1% compared to the 3rd quarter of 2009, and even this drop only wasn’t larger due to the availability of EU infrastructure funding, since the volume of building construction decreased 9% while the volume of civil engineering increased 15% at constant prices. According to data from the Estonian Register of Construction Works, in the 3rd quarter of 2010 there were only 481 housing units completed - 50% down on the same period of 2009. 65% of these were flats, the majority majority of them in Tallinn.

As the Central Bank point out, domestic demand can only improve in a sustained way if there is a major improvement in the labour market, but as they also stress, this is only recovering slowly, with the unemployment rate declining to 15.5% in the third quarter, and with the need to improve productivity and only low growth expected in the quarters to come, unemployment is likely to remain high for several years.

So despite the recovery in external demand, as was to be expected the demand for domestic credit far from recovering continues to contract, whether we are talking about corporates:

or about households:

or about housing mortgages:

Added to this, the way that fiscal austerity was implemented (raising VAT, and fuel costs) has meant that the Estonian price level, far from continuing to deflate (which is what is needed to increase competitiveness quickly enough) is now rising again, and at around 5.5% (my estimated HICP, the Estonian CPI was up 5.7% but the weightings are different) is well above the 2.2% estimate for the Euro Area, or the 1.9% December inflation estimated for Germany by the Federal Statistics Office. Perhaps one of the clearest indications of the malfunctioning of the Eurozone as currently structured is that the Germany economy (which is recovering rapidly) is experiencing far higher levels of inflation than the Eurozone periphery, which in theory should be deflating to recover competitiveness.

True Estonia did begin to recover some part of the lost competitiveness, and unit labour costs as compared with some key competitors did start to improve, but this process slowed considerably in the first two quarters of 2010, marked time in the third one, and may actually have started to deteriorate again in the final quarter as inflation accelerates (OECD data - please click on image for better viewing).

Hourly wages (on a moving average basis) seem to have stopped falling, and the next move will almost certainly be up as inflation bites in.

True, the Central Bank would undoubtedly argue that much of the inflation was due to food and energy, and that core inflation was running much lower (1.2% in November), but it is hard to see the impact of movements in the leading CPI not feeding through into wages, and producer prices (another important measure of industrial costs) were up an annual 4.5% in November.

And Its A Hard Road To Travel!

In his most recent assessment of the Estonian situation (Toughing It Out: How the Baltics Defied Predictions) Christof Rosenberg (former coordinator of the IMF baltic intervention, and current head of the Fund's Hungary mission - this man also likes hard challenges!) also pays hommage to the grit and flexibility of the Baltic populations (a characteristic I also wholeheartedly applaud), but he draws a conclusion which I feel is as yet at best premature.

"The Baltic experience demonstrates that large economic adjustment, including nominal wage and benefit cuts, is indeed possible under a currency peg (or, for that matter, in a currency union)".

Certainly, as Christoff points out, a large correction has taken place in Estonia. The current account, for example, is now in surplus.

The issues I am raising is whether this correction is enough, or whether it is sustainable. As the Bank of Estonia note, the Non-performing loans situation has been stabilised, and the value of loans overdue for more than 60 days contracted by over 250 million kroons in November to stand at 6.8 per cent of the total loan portfolio. But most of the old loans are still there, they have not been cleaned from the books, and have been sustained and refinanced by what Christoff calls the "deep pockets" of the Scandinavian lenders. These loans would be once more put into question by any renewal of the internal devaluation and serious price deflation. So hard decisions are going to need to be taken.

Inflation is already excessive, and net-exports are nowhere near large enough as a proportion of GDP to carry the economy forwardwith a strong growth dynamic. Thus, I think it is very true to say, as Christof does, that it still far too early to pass any kind of definitive judgement on the success of what he calls "the Baltic strategy". There is still a very long hard road out there in front, and the hardest and steepest part may well be yet to come.

Estonia's Now-You-See-Me Now-You-Don't Inflation Rate

2010-10-11T16:10:00.001+02:00

Just to follow up on my recent long Estonia post, a couple of new data points have caught my attention recently: the sharp rise in Estonian inflation and the ongoing goods trade deficit.

In the first place it is worth noting that Estonia's trade deficit went UP again in August. Of course, the countries ongoing services surplus takes some of the edge off, by, since Estonia is now an export driven economy, to return to stable growth and create that much needed employment Estonia needs a trade surplus, not a deficit. Of course, the headline catcher is that August's export were up 37% over August 2009. The number looks a little less impressive when you notice that imports were also up by 34%, and take in that a significant proportion of exports are imports which are re-exported, and then you look at the chart (below) and see that both are still running at levels well below their pre crisis peaks.

To add insult to injury, despite the rapid export rise, Augusts trade deficit - some 71 million euros - actually increased slightly when compared to August of the previous year.

And here's the smoking gun which can help us understand why, despite the legendary "internal devaluation, the underlying Estonian trade deficit continues: the ongoing surge in inflation, itself in large part a by-product of the tax increases and energy subsidy reductions made to keep the fiscal deficit under control .

According to Statistics Estonia, the consumer price index was up by an annual 4.0% in September, and by 0.8% when compared to August this year. Goods were up 4.5% and services 3.0%. Food prices were part of the problem, since they were up 7.0%. But, as the statistics office report informs us, government administered prices of goods and services were up by 8.1% while non-regulated prices were only up by 2.7% - that's the giveway datapoint, I think.

Two fifths of the inflation was the result of a 6.6% price increase in food and non-alcoholic beverages, but the 10.2% price increase of electricity, heat energy and fuels accounted for 25% of the total, and the 8.2% excise duty induced price increase in alcoholic beverages and tobacco also had a significant impact on the consumer price index.

So inflation is rising, but even worse, so too are inflation expectations.

Inflation expectations by Estonian consumers continued to rise in September, according to Konjunktuuriinstituut, an economic research institute in Tallinn. The outlook is “certainly” affected by the prospect of euro adoption, the institute said.

Thirty-five percent of consumers polled by the institute this month expect inflation to accelerate in the next 12 months, compared with 32 percent in August, and 5 percent a year earlier, it said.

So, if those taking the policy decisions aren't careful Estonia may be about to loose its "poster boy" image, and find itself added to the ranks of the "fallen angels". The above comparison of Euro Area 16 and Estonia CPI inflation makes it look awfully like the timing of the tax and subsidy changes was calculated to get good inflation readings during the key euro decision window. It is hard to believe that neither the central bank nor the ECB couldn't see the current surge coming - or if they couldn't, then the best you could say is that they were extraordinarily incompetent in their handling of the issue. And if you look at the competitiveness loss the price index reveals since the start of 2007 (even) the short period of deflation has nowhere near compensated for it, and the current price surge will soon eat it what little competitiveness improvement there has been all away.

Of course, the central bank has expressed some concern, “There is a threat the present price and wage levels will not sufficiently support new investment and job creation,” it said in its latest economic report, although it stressed that it considered the increase in ongoinginflation due to rising food prices is likely to be temporary.

All of which only confirms my impression that the Estonia entry decision was made in haste, coinciding as it did with May's sovereign debt crisis. The decision was a kind of vote of confidence in the resilience of the Euro Area: "look, we aren't about to fall apart, we're even accepting new members". In fact ECB President Jean-Claude Trichet almost said as much on a recent visit to Tallinin. Europe's economic and monetary union is committed to accepting further members, he stressed. "The euro area is not a closed shop," M. Trichet said, while attending a festive event to celebrate Estonia's upcoming accession to the eurozone. Rather, he said, it is open to any country "that fulfills any of the preconditions in a sustainable manner."

The keyword here is "sustainable". As reported on this blog, there were those within the ECB, and most notably ECB executive director Juergen Stark, who opposed the decision, by simply arguing that, in the light of Greece's inability to endure the discipline of EMU membership, future applicants should be screened more tightly. In the past, membership had rested on the ability to conform with numerical targets on inflation, public debt and exchange rate at a specific point in time. Stark spoke of the need for countries to demonstrate that their compliance with the entry criteria is sustainable beyond the snapshot moment. As we can see, at least in terms of inflation, it is very hard to argue that Estonia's economic performance is.

Jean-Claude Trichet also took advantage of his visit to stress that Estonia must remain “alert” on price developments and take “forceful” action to stem inflation after joining the euro-region economy. But, understandably, Prime Minister Andrus Andrip replied that Estonia is now going to have relatively “few tools” to control price increases. The main technique available is to run a fiscal surplus to drain demand, but with an economy which is suffering from the level of output loss that Estonia's is this is hardly contemplateable.

Basically it would have been much more advisable to resolve these issues before joining the euro, but now it is a little late for that, so, who knows, maybe Estonia will eventually become the first candidate for the recently proposed EU imbalances surveillance mechanism.

As the press release puts it: "The global economic and financial crises, followed by the so-called debt crisis, exposed the need for reinforced economic governance in the Economic and Monetary Union (EMU). Economic policies need to be better co-ordinated and surveillance enhanced".

"Surveillance would start with an alert mechanism that aims at identifying Member States with potentially problematic levels of macroeconomic imbalances. The alert mechanism would consist of a scoreboard complemented by expert analysis".

"The scoreboard would be composed of a set of indicators in order to identify timely imbalances emerging in different parts of the economy. The set of indicators should be sufficiently large to cover any possible case of major imbalance and making sure that it is sufficiently sensitive to detect imbalances early on. Possible indicators would most likely include both external (e.g. current accounts, real effective exchange rates) and internal ones (e.g. private and public sector debt). The composition of the scoreboard may evolve over time due to changing threats to macroeconomic stability or advances in data availability".

"Alert thresholds would be defined and announced for each indicator. The thresholds should be seen as indicative values which would guide the assessment but should not be interpreted in a mechanical way. They should be complemented by economic judgment and country-specific expertise".

But looking at that rising inflation profile, and thinking of Prime Minister Ansips statement that the country has few tools left with which to tackle the problem, whoever would have thought that just a few short years ago Lithuania had its application to join the Euro turned down simply because its inflation wasn't considered to be sufficiently under control. My, my, how things change.

On account of its 2.63% March 2006 inflation, Lithuania has for now failed to qualify for the euro zone, while Slovenia is all set to adopt the euro in January 2007.

Lithuania meets all the criteria for the adoption of the common European currency, except for the one on inflation. The Baltic state's latest inflation figure is only marginally higher than the 2.60% benchmark applied by the Commission and the European Central Bank to decide whether a country is fit to adopt the common European currency.

According to Monetary Affairs Commissioner Joaquin Almunia, the criteria, laid down in the EU's Stability and Growth Pact, are there to be rigorously enforced.

Estonia's Long Awaited Recovery May Still Be Delayed Yet Awhile

2010-08-22T22:47:00.000+02:00

In a recent FT Op-ed, entitled "Estonia’s recovery defies economists and academics", columnist John Dizard argued that "the “internal devaluation” policy, which means cuts in nominal costs such as wages and rents, was very hard on the population, but appears to have worked ahead of even the Estonian government’s schedule".

But as I said to John in a very enjoyable phone conversation I had with him before he wrote the piece (where he was kind enough to descibe me as a "freelance economist", one who doesn't have to answer to a boss before expressing an opinion), perhaps we should just hold on a minute before jumping to too many conclusions, since things are still far from clear. So let's take a look.

As John points out, many macro economists, among them me myself (here, and here, and here) and Paul Krugman (here) have been arguing that if the Baltic countries stick to their policy of having a fixed exchange rate with the euro, they face a long period of low growth and serious internal deflation. At the start of this debate, I pointed out that the impact of price deflation on the bank loan books would be just the same with or without devaluation: not so, said Krugman (and he was right), the impact is worse, since even the Kroon or Lati denominated loans (which in truth are quite few) are affected.

John however, does not agree, since, he tells us, the country is "stubbornly failing to comply with the predictions of what are called the 'third generation models' for currency crises" and "is already seeing a resumption of growth and a fall in its real cost of capital".

Well, as I told John at the time, the Estonian case is a complex one, since in a country with only just over a million people a myriad of special case factors can be at work, confounding results. But still, the idea is abroad that Estonia is a kind of "black swan", a data point which tends to suggest that conventional macro economic wisdom is somehow flawed. So just how valid is this view. Let's take a look at some data.

In the first place, John is undoubtedly right, economic activity has revived (slightly) in Estonia. In Q2 2010 the economy grew by a seasonally adjusted 2%, following an equivalent contraction in Q1 and growth of 2.6% in Q4 2010 (yes these are quarterly, not annual, numbers).

So the first thing to say is that if these numbers are truly well adjusted seasonally (which make be hard given the boom bust background, and the amplitude of the movement in the data) what we have is a lot of volatility out there. And in the second place, we could well ask ourselves to what extent it is valid to use that so-oft maligned expression "recovery" at this point in the Estonian context. If we look at the GDP volume index (which I have put in 4 quarter moving average format), you have to look very hard indeed (go on, squint a bit more) to actually see the uptick.

I tell you what, I'll do you all a favour, and shorten the time series and change the scale.

Well, that's a bit clearer, isn't it. I think what you can say looking at this chart is that the Estonian economy has been stabilised (no mean feat that, with an economy in freefall), but what happens next, well that, it seems to me, you can't discern from looking at the chart. To decide on that, I think, you will probably need to go back to the initial assessment you had of the problem. If, like John, you believed that what the Estonians were trying was doable, then you will probably draw the conclusion that what comes next will (eventually) be a recovery. If, like me, you had severe doubts from the outset that this was doable, then you will probably imagine the Estonians are now in for a long period of slow, "L shaped" semi-recovery, with a lot of pain still to come, further down the road. But as I say, all of these expectations probably depend on your initial theoretical assumptions (more on this later), and in that sense nothing has fundamentally changed.

That being said, there are some things that have improved in recent months. Retail sales for example.

And then there is industrial output, which is up sharply. It even almost looks like the fist leg of one of those proverbial "Vs".

And part of the reason for this improvement in output has been the recent improvement in demand for Estonian exports.

But before we get too excited about all this, we should remember that Estonia still has a goods trade deficit. That is, on balance, the net goods trade is a drag on GDP.

The problem is that the part of Estonian industry which was internationally competitive before the bust still is, but that this part is not large enough to drive the whole economy, now that the economy is export dependent. It just doesn't have a big enough share in GDP to carry the whole economy. As the Estonian statistics office put it: "GDP growth in the 2nd quarter was supported by the industrial sector exports. Due to a small domestic demand, the sales of manufacturing production on the domestic market were in downtrend. In construction, the output of which is mainly targeted at the domestic market, the generated value added showed a continuous decreasing trend".

This is what I had always expected would be the case.

It should be noted that Estonia runs a substantial services surplus, which at the present time easily cancels out the goods trade deficit. As a result, and this IS the good news, Estonia now runs a current account surplus. Which means that each month now, instead of getting more into debt, the country is steadily paying down its international liabilities. And this is important, since as John points out, Estonia is considerably less indebted externally than many other of Europe's peripheral economies, with net external debt according to IMF data only being some 30% of GDP.

But nonetheless, achieving this positive situation still has a price, and that price is that the economy is being forced to operate at well below capacity level, and the clearest indication of this is the very high continuing level of unemployment. In fact, I think John got interested in his story when he read this report, that the registered unemployment rate in Estonia fell to 12% in mid-July. Since he was aware that first quarter unemployment was somewhere around 19%, this seemed to him like a dramatic drop. But there is a confusion here, since we are dealing with two different measures of unemployment, one of them people who sign at labour exchanges to register as unemployed (and may do so because they have entitlement to unemployment benefit), and those assumed to be really unemployed when measured using ILO compatible (and EU harmonised) quarterly labour force surveys, and as this article points out, according to the latest of these surveys (April - June) there were still 128,000 unemployed, or 18.6 percent of the workforce out of work in June.

Of course, interpreting such data presents its own problems, and the issue is a complicated one, since in the first place there seems to be a large shadow economy in Estonia. According to Professor Friedrich Schneider of Austria's Linz University, based on a study that covered 37 countries, Estonia had the second largest proportion of GDP in the informal economy, with some 40% not paying tax. Top of the list was Latvia, with shadow economy accounting for 42% of the country's GDP, then came Estonia, Bulgaria, Turkey and Greece. So of course, not all those who are not signing the registers are necessarily unemployed, or in the country even, but still people are dropping out of the statistical system, according to the Estonian Health Insurance Fund some 20,000 less people are registered for health cover today than there were in March 2008. At the very least we can assume these people are not working in the formal economy or registering for welfare benefits. Whether they are working in the informal one, or working abroad, we really have no idea.

Be that as it may, according to the Estonian Statistics Office, in the 2nd quarter of 2010 the estimated number of unemployed in Estonia was 128,000 and the unemployment rate was a - seasonally not adjusted - 18.6%. So unemployment did decrease in the quarter for the first time in nearly two years, but by 1.2% (from 19.8% in Q1), and not by the rather large amount it might appear from the labour exchange registration data.

And if you go to the details of the stats office report the situation is more complex than it seems at first sight, since while the number of new unemployed has been declining, long-term unemployment continues to grow. In the 2nd quarter, 58,000 unemployed persons had been looking for a job for one year or more (long-term unemployed), of whom 19,000 had been looking for a job for two years or more (very long-term unemployed). The share of long-term unemployed among total unemployed increased to 46%, while the share of very long-term unemployed rose to 15%. The number of persons who had stopped seeking a job or discouraged persons was also larger in the 2nd quarter than in the 1st (9,000 and 7,000 respectively).

On the other hand the estimated number of employed persons was 559,000, which was up by 5,000 (0.9%) over the previous quarter. According to the statistics office, "employment increased due to seasonal and other temporary jobs typical of the 2nd quarter". Nonetheless there was employment growth, so we should be thankful for any mercy, however small. What remains to be seen is whether this improvement in employment is sustainable as Europe's economies slow going into the second half of the year.

A further bone of contention between the parties evidently concerns the so-called “internal devaluation” policy being applied by the Estonian government. As John Dizzard explains such a policy "means cuts in nominal costs such as wages and rents, (and) was very hard on the population, but appears to have worked ahead of even the Estonian government’s schedule".

When we come to scrutinise the actual data however, the fall in hourly wages has hardly been dramatic, and they have now fallen about 7% from their peak at the end of 2008. But it should be remembered in 2008 they were up by around 7%, so they are now at about the same level as they were in January 2008, following increases of 17.5% in 2006 and 20% in 2007 - rates of increase which ultimately lead to the consumption bust which followed them, and clearly not sustainable in the longer term. So, unfortunately it is just not the case that Estonia has had a very harsh policy of wage cost reduction implemented. Living standards have fallen sharply, due to the reduced hours worked, and the rapid rise in unemployment - ie due to the recession - but that is not the same thing at all as recovering lost competitiveness.

The Real Effective Exchange Rate data on all this is very clear. Up to 2005 the rise in living standards was more or less in line with sustainable economic growth. From 2006 onwards things really got out of hand, and to date only a very small part of the competitiveness loss has been clawed back.

This intrepretation is confirmed by an inspection of the CPI data, which after 9 months of registering mild interannual deflation is now back in positive territory, and more or less a full percentage point above the Eurozone average, which for a country which is supposed to be in the throes of a substantial "internal devaluation" is pretty incredible, and could be seen as another example of someone or other falling asleep at the wheel, after passing the finishing line for Eurozone membership perhaps.

John Dizzard argues that the Estonians are in position for a relatively rapid recovery (this part I don't see at all, anywhere in the data) because they started out with much less state and private debt than the others. This latter point is certainly true, but we should not miss the fact that while Estonia's state debt is very, very small, private sector debt (at around 100% of GDP, between households and corporates) is not so small, and indeed will continue to exert a significant downward pressure on credit growth for some time to come.

Now one of the points raised by John which does have a certain validity is that of lower capital costs. Given the existence of significant quantities of land and warehouse and factory accommodation which are now surplus to requirement due to the "downsizing" which has been going on (creative destruction) employers do now have access to cheaper premisses, and this can offer them lower unit costs for a given level of technology and output. The key point to get here is where the demand is going to come from, and then we are still back with the same issue: exports.

More than the internal devaluation itself, Estonia is benefitting from the decision to grant the country Euro membership. As a result the cost of servicing oustanding debt has falling, as have credit default swap spreads. John quotes one large shareholder in several Estonian companies as saying, “At the beginning of 2009, the banks were offering our companies loans at 600 to 700 basis points above six-month euribor [the euro base rate]. That’s if the money was available at all; most of the time they were cutting lines. Now the banks are offering the same companies increased lines at 100 to 300 basis points over euribor.”

But if we come to look at the impact of this cheap credit, we will see that, as in other economies where private demand is highly leveraged (the UK, the US, Spain), the uptake on all this ultra cheap credit has not exactly been massive. In both cases the interannual rates of credit growth are still negative, which is one of the key reasons domestic demand remains so weak.

Although we can see the first timid signs of recovery in the housing market, both in terms of sales volume and in terms of prices, but at this point they are just this, timid signs.

So to go back to where we started, and John Dizzard's claim that "Estonia’s recovery defies economists and academics", I would say that rather than economists and academics (or even academic economists) who Estonia's current situation does really defy is the group of people over at the ECB governing council headed by Jürgen Stark, since, as I reported back in April, consensus thinking at the ECB was that Estonia was not coming into the common currency , due to ongoing concerns about sustainability and competitiveness issues.

But that was April, and then came May, when the ECB was forced to do a "U turn" by the crushing pressure of the European Sovereign Debt Crisis, so all these (valid in my view) concerns where simply brushed aside. And anyway, how could anyone argue for keeping Estonia out on these grounds, when you have countries like Spain and Portugal on the inside. Either internal devaluation works, or....

So maybe it was better for them to stay with the line that internal devaluation works, and whether they are right or not is what we are all about to get to see. As I said at that start the post, in this case as in so many others, beauty is in the eye of the beholder. If you believe in the neo classical (academic) theory of "steady state" growth - and the guy over at Swedbank that John cites who is forecasting that Estonian gross domestic product will grow at a 4.5 per cent rate next year evidently does - then naturally Estonia's economy has only been temporarily knocked off its path by this whole unfortnate incident, and will soon be back in it habitual orbit.

If, however, like me you suspect that neo-classical steady state growth is some sort of metaphysical hocus pocus (or what they call a "necessary assumption to get the argument going") with little empirical support, then you will not be terribly convinced by all those numbers blindly and slavishly churned out by the current generation of models, and will look more to the facts on the ground. In particular, when we come to the neo classical growth theories which normally underpin the sort of optimistic analyses we see of the Estonia situation (yes John, there are academic economists on both sides), I tend to think these are flawed due to some initial erroneous assumtions Solow himself made about the impact of population dynamics on growth (see this extended argument here), and I think it is important to remember here that Estonia, along with Hungary, Latvia and Bulgaria, is one of the countries on Europe's Eastern flank where population as well as ageing is actually falling. So I suggest you treat any analysis which talks about a steady recovery in internal demand but does not explicitly explain how this point has been taken into account....... well I suggest you treat it with more than a pinch of salt.

And then, of course, there is the idea of "export dependence" and ageing, and what this all means for the future trajectory of the Estonian economy. This argument, which Claus Vistesen and I have been advancing for some years now (and is one of the reasons so many of those famous "predictions" turn out to be valid), shot to the financial headlines recently when Dominic Wilson and Swarnali Ahmed of Goldman Sachs drew the obvious to everyone's attention - namely that balance of payments current accounts are significantly driven by life cycle savings. Maybe you can argue about the validity of the age group classifiaction they use (an empirical calibration issue), but the obvious is obvious: the relative proportions of different age groups across different countries goes a long way to explaining the pattern of global savings and capital flows. And as Claus Vistesen illustrated in the chart below, this helps us understand how societies (Germany, Japan...) become increasingly export dependent as they age.

So, as I said earlier, your expectations about the future outlook for the Estonian economy will largely depend on the initial theoretical assumptions you make at the outset. If you assume that neo classical steady state growth really exists, and that all this stuff about ageing, capital flows and export dependence is exaggerated, then you will see the recovery coming in the here and now, and if you don't.........

The Social Impacts of the Economic Slowdown: The Latvian experience

2010-07-20T22:10:00.000+02:00

Guest Post by Eliana Marino

The economic and financial crisis that started in 2008 seems to be on its way to being overcome by many EU member states, but the population in some of the most touched countries is still labouring under the ongoing effects of the slowdown. Latvia, which underwent an annualised decline of 18% of GDP in the first quarter of 2009 and still has the highest unemployment rate in the EU, is experiencing a veritable revolution in its population structure and is preparing to face serious demographic challenges.

The strong recession experienced in the last few years has sadly confirmed the high propensity of Latvian people to migrate for economic reasons and generated a real “exodus” of working age population.

Before 1999, a peak of emigration was registered due to the endogenous migration potential of the collapsed Soviet Union, but, from 1999 to 2002 the outflows seemed to stabilize and to show a slowing trend. This trend changed with the accession to the European Union and the immediate application of the free movement of labour by UK, Ireland and Sweden, which decided to open their borders to New Member States immigrants without any transitional restrictions. These conditions created an increase in the number of emigrants in 2006 and the “old” member states definitely replaced the Russian Federation and the ex Soviet Republics as main countries of destination.

The decline of the outflow in 2007 is linked to Latvian extraordinary economic growth which appeared to guarantee an increase in the wellbeing of the population. This situation started to deteriorate in the second half of 2008, generating a new rise in emigration decisions and increasing more and more in the following year.

Net migration has always been negative and, combined with a Total Fertility Rate among the lowest in EU, it strongly contributed to a progressive and continuous decline of the total population.

Official data, as analyzed above, cannot provide a real portrait of migration dynamics in Latvia. While the registration of immigrants is enough reliable due to the strict controls at the external borders of the EU, emigration statistics are completely unreliable because the large majority of emigrants did not declare its departure and no alternative method is adopted to catch up their real number. The gap between registered and factual data is showed by the comparison with statistics provided by the destination countries, as showed in the graph below:

More recent data were collected through the EU funded project The Geographic Mobility of the Labour Force , consisting of a survey conducted in 2007. The study arrived at the conclusion that a bit more than 40˙000 people emigrated between 2004 and 2005 (87% more than registered data). The authors forecasted that intensive emigration was expected to continue and that, looking at the number of respondents who said that they wonted to leave and at those who already did something in pursuit of this dream, by 2010 between 10˙000 and 16˙000 people were supposed to leave Latvia, thus totaling 50˙000 to 80˙000 emigrants from 2004 to 2010.

These estimates were presented in 2007 when Latvia was going through a period of sustained economic growth and no one could even imagine the economic collapse which the country is undergoing in this moment.

The survey, which I personally conducted in Riga from September to December 2009 and which involved some of the major Latvian experts on migration issues, showed that around 30,000 people are supposed to have left Latvia in 2009 and the same number is forecasted also for 2010.

These massive emigration flows from Latvia can strongly affect the future demographic and economic structure of the country, creating serious problems of labour shortage, unsustanability of the pension system and huge population decline.

Since the years of great economic growth, Latvia experienced a huge problem of labour shortage due not only to the lack of high skilled professionals but also to the general discrepancy between demand and offer of labour. In 2006-2007 this situation was one of the main topics of political and public debate and, under the pressures of the enterprises, the government approved a more liberal immigration policy in order to select labour force from abroad.

The downturn of 2008 caused an inversion of the trend: enterprises were obliged to reduce the labour force and the employment rate decreased together with the level of wages. These elements represented the main push factors for emigration and they are currently generating a real “exodus” of the labour force, creating dangerous structural problem in Latvian economy. Actually, lack of labour and especially of high skilled professionals will be a veritable challenge for the economic recovery of the country and nowadays it is one of the main reasons of concern for Latvian politicians and intellectuals.

From the demographic point of view, the impact of emigration can be considered under two different aspects:

- emigration of working age population makes the demographic burden increase: the number of inactive people (children and retired people) exceeds the number of active people, creating serious challenges for the sustainability of the welfare system;

- the most part of the outflows consists of working age population (from 15 to 65 years old) that includes people in reproductive age (from 15 to 49 years old). A huge number of emigrants in this particular age group means a further reduction of the natural increase of the population. In fact, they will probably have their children abroad or the migration decision itself will discourage the creation of numerous families.

This situation has to be combined with the low levels of Total Fertility Rate which characterize the country since more than 20 years ago. In Latvia, the first demographic transition to a rational regime of reproduction began at the end of XIX Century and the total fertility rate was lower than the replacement level already in the second half of the Century, due to repressions and harsh living conditions during the wars and the Soviet occupation. The replacement level was met only in the 80s after the introduction of partially paid child birth leave. Since then, the birth rate has decreased to unprecedented level and has represented an issue of serious concern for Latvian government. In particular, the decline of total fertility rate accelerated during the economic and political transition, since the Soviet centralized welfare collapsed and the national government opted for a shock therapy instead of a gradual and progressive transition to the market economy.

However, Latvian government recognised the need to ensure reproduction of the population as a prerequisite for the nation’s existence and started to evaluate adequate tools for family support. The adoption of successful family policies made the birth rate level stabilize since 1999 and start to increase at the beginning of the XXI Century. Anyway, the total fertility rate never reached the replacement level and it is still among the lowest in the EU (average 1.4 children per woman in the period 2005-2010 ).

As a consequence of these indicators, Latvian population dropped from 2.5 to 2.2 million people in 15 years and the negative growth rate is expected to accelerate in the next years.

The experts interviewed in the last months of 2009 proposed different solutions to both economic and demographic challenges but they agreed on the fact that a more liberal immigration policy might be really helpful to solve problems of labour shortage and pension sustainability as well as to contribute to the inversion of the negative demographic trends. However, this proposal, which is one of the main topic of public debate since the economic boom, is in direct conflict with the hostility of national population toward immigrants. Latvian critical historical experience with integration of different ethnicities is the clearest explanation of this hostility and probably some years are still needed to overcome these cultural barriers.

In definitive, the results of the survey allow to conclude that Latvia needs some important structural reforms (concerning an efficient social policy, a comprehensive population policy, a strong action against corruption and a reduction of the bureaucratic burden) to be implemented by the national government in order to prepare the country to play its role at the European and international level and to take the best advantages from the opportunities provided by the integration and globalization process. The first step to achieve this objective is the promotion of a cultural change whose main goal is to dump the “dependency from the past” and to open mental and factual borders to modernity.

Footnotes

1/ Latvija Statistika (Central Statistical Bureau of Latvia), www.csb.gov.lv, accessed on April 17th 2010

2/ Herm A. et Al, THESIM-Toward Harmonised European Statistics on International Migration, Country Report Latvia, Sixth Framework Programme, priority 8.1: Policy Oriented Research, Integrating and Strengthening the European Research Area, December 2004

3/ Krišjāne Z. et Al., The Geographic Mobility of the Labour Force, National Programme of European Structural Funds “Labour Market Research”, project “Welfare Ministry Research”, University of Latvia, co-financed by the European Union, 2007

4/ Eglīte P., National Policy for Increasing the Birth Rate in Latvia, in Humanities and Social Sciences Latvia, University of Latvia, Institute of Economics-Latvian Academy of Sciences, 2008

5/ UNdata, www.data.un.org accessed on January 30th 2010

Latvia: Living in the Land of Extremes

2010-07-20T22:08:00.000+02:00

Guest Post by Morten Hansen, Stockholm School of Economics in Riga

Here in Latvia the internal devaluation continues and the debate is whether the economy is flexible enough for this experiment. I say perhaps it is, Edward says perhaps it isn’t but one thing is for sure: the Latvian economy is (possibly perversely) indeed flexible.

I would like to illustrate this point with a series of numbers for the extremes that we have witnessed in Latvia so in the following I list a series of macroeconomic variables and the times at which they were at their extremes during the boom and during the current bust. After that I try a little discussion of why the development was so extreme here.

Numbers are from the Central Statistical Bureau of Latvia and from the Bank of Latvia, I use monthly data when I can, otherwise quarterly. All growth rates are y-o-y.

GDP growth – from the biggest increase in the EU to the biggest decline
2006 Q3: +12.7%
2009 Q3: –19.1%

Inflation – the highest inflation rate in the EU becomes the biggest rate of deflation in less than two years
2008 V: +17.9%
2010 II: –4.2%

Wage growth – again both are extremes also in an EU context
2007 Q3: +32.9%
2009 Q4: –12.1%

Unemployment rate (among 15-64 years)
2007 Q4: 5.4%
2010 Q1: 20.7%

Current account (% of GDP) – has anyone ever seen a +40 percentage point turnaround in the current account balance in less than three years?
2006 Q4: –27.2%
2009 Q2: +14.2%

Credit growth, households
2003 VIII: +85.8% (an early spike but growth rates in excess of 60% continued for several years)
2010 IV: –5.1%

Credit growth, firms
2006 II: +54.7%
2010 III: –7.9%

Money supply growth (M2)
2006 X: +43.9%
2009 VIII: –12.5%

Closely linked to the three latter sets of statistics one can note that house prices dropped some 53% in 2009, see here p. 6, again the largest decline in the EU, while several years during the boom had recorded increases around 60% y-o-y.

But one variable hasn’t changed and here I am of course thinking of the exchange rate which remains at a parity of 0.702804 LVL/EUR and is managed in a narrow +/–1% band. Those who follow Latvia will know, however, that there were great market uncertainties surrounding the peg first in March 2007 then in November 2008 (at the time of the nationalization of Parex Bank) where 10-14 November was the week with the biggest ever intervention by Bank of Latvia, which sold 267.65 mill. EUR. Altogether mid-November – mid-December saw a loss of some 18% of foreign reserves – more details on interventions here. In terms of interest rates the June 2009 scare saw the overnight interbank rate (RIGIBOR) peak at 33% on 26 June.

Latvia is not the only country with a credit boom, with a housing boom or with problems of overheating but one may ask why it was so violent here, why almost all numbers were and are more extreme. I shall try to provide some explanations below.

1. The Latvian credit boom was not just a boom, it was more of an avalanche as it represented the emergence of the financial sector. Whereas loans to individuals and enterprises constituted some 16% of GDP in 2000 this reached 91% of GDP in 2008 X, when loans saw their peak.

2. There was a naïve belief in rapid income convergence both among politicians (see this story from the Baltic Times in 2006 where a goal was formulated by Latvia’s First Party to raise Latvia’s standards of living to those of Ireland in ten (!!!!!) years….). This belief must at least to some extent have been shared by the banks since it can explain why they provided large loans compared to actual income.

3. The belief – or certainly the hope thereof – was strong among ordinary people, too. For decades during Soviet rule most had been denied the possibility of one’s own flat or car. Thus it is not surprising that when something called a loan appears as a possibility, many took it. One may also call it the result of a financially uneducated people which is not to say that such do not exist elsewhere, just look at the subprime market in the US or Brits (and others) buying summer houses in Bulgaria or Turkey.

4. Latvia’s fiscal policy was highly procyclical during the boom thus exacerbating this boom; major consolidation efforts now act as similar procyclical fiscal policy, this time exacerbating the bust.

5. Too late (2007) Latvia introduced a credit register – there is a story about one person who managed to borrow from no fewer than 25 different banks….

6. Latvia has many more banks than Estonia or Lithuania and this perhaps led to more aggressive and less prudent lending to keep up market shares.

7. Some also suggest that due to the attractiveness of Riga and its seaside resort/city Jurmala to people from Russia even more froth was created in the Latvian real estate market.

8. The public economic-political debate was poor in the ‘fat years’ and it was somehow ‘unpatriotic’ to argue that problems were building up.

9. And, lastly and more speculative, but I could imagine that some of the Swedish and other foreign banks that entered brought with them a perception at the subconscious level of the Latvian market being similar to their home markets in terms of customers’ realism and honesty, features that were not always met. Some customers had unrealistic expectations of their future pay (but can you really blame them when wages were growing in excess of 30% a year?), some were most likely dodgy customers from the outset and the banks were a tad naïve. I am speculating but from conversations with bankers I am also sure I am right….

And in the end one may just wonder what the total cost of miscalculations due to an environment of extreme macroeconomic uncertainty has been for individuals, enterprises, banks and the public sector.

To end on a lighter note: At the time of writing the outdoor temperature is +32° (90F), which is hot here. Less than half a year ago we had temperatures down to –30° (–22F) so Latvia is not just extreme with respect to economic indicators.

Is Estonia's Euro Membership A Done Deal?

2010-04-16T17:35:00.000+02:00

Well, if you read this report from Euractiv, citing unnamed EU Commission officials, it is:

"If nothing extraordinary happens, the Commission will give its positive opinion for the accession of Estonia to the euro zone on 12 May," an EU official said, clearing the way for Baltic country to join the euro in 2011.

There just one little snag here: that extraordinary, "fat tail" event seems to have just happened. For the Commission to be able to move forward on Estonia's Euro Membership, the ECB have to agree. And it is here that Estonian journalist Mikk Salu steps in (in Estonian in the newspaper Eesti Päevaleht, summarised in English here) and says "not so fast". Salu reports on a closed-door meeting of the Economic and Monetary Affairs Committee of the European Parliament held last Tuesday (April 13). The meeting had a single-item agenda: Estonia's membership of the Eurozone, and the meeting was attended by ECB Executive Board member Jüergen Stark. According to MEPs who attended the meeting (but did not wish to be identified), Stark was "stark": Estonia is not going to be admitted. The reason given was that in the wake of the recent crisis affecting the Eurozone, new criteria will be introduced - including per capita GDP and competitiveness sustainability - and on these counts Estonia will not qualify.

Salu also spoke to Estonian MEP Ivari Padar, who attended the meeting and confirmed the substance of the discussion, although Padar did try to mediate the situation slightly, saying, "you know, he is a central banker, and central bankers are a conservative lot", etc etc. On phoning the ECB itself and the Commission the only reply he got to a straight question seems to have been "no comment".

Basically, as I said, maybe the ECB are a conservative crowd, but I think it is very hard to see Estonia being admitted to the Euro without ECB backing, and indeed looking at what is happening over in Greece at the moment, and in the German Constitutional Court, I think it is very hard to see any new members at all in the immediate future. Consensus thinking right now seems to be more towards small(er) is more beautiful.

None of this surprises me, indeed when I wrote my last post on Estonia, back in February, it seemed to be an increasingly likely outcome.

But as Fitch pointed out when they raised their Estonia outlook, while eurozone membership looks increasingly possible it is not yet certain. Fitch warned in their report that even if Estonia meat all the formal Maastricht reference criteria for euro entry there is still a risk that the European authorities' interpretation of these same criteria could lead them to reject Estonia's application. According to Fitch, in Estonia's case uncertainty surrounded whether the idea of "sustainable price performance" was going to be consistent with the deflation which is to be expected from such a severe recession, after inflation had so recently been in the double digit range. The agency also added that one-off measures taken by the government to reduce the budget deficit in 2009 could also count against it in the EU authorities' judgment of whether the medium-term budget plans are credible.

The first point is an important one I think, and is reiterated by the ECB's own Jürgen Stark in an interview given to the German magazine Der Spiegel for this weekend: "But when taking on board new members, we will need to take an even closer look, concerning the data and the sustainability of convergence," he is quoted as saying.

Indeed if we go back to the 172 page EU Commission document leaked to the German magazine Der Spiegel last month, the EU Stability and Growth Pact is increasingly going to focus on issues surrounding competitiveness as well as on fiscal deficit ones. That is what the whole deabate over the Greek and Spanish economies which EU leaders are engaging in this week is all about. And any country which is not considered to be in completely good health under the SGP criteria is hardly likely to get the green light from the ECB and Ecofin.

It is obvious that the Estonian economy is still suffering from earlier structural distortions which have not yet been corrected. If we come to the consumer price index, this was only down about 2% in 2009, far short of the deflationary adjustment which will be needed to restore growth and competitiveness.

And to cap it all, for the first time since the start of the financial crisis, Moody's has chosen this, of all, moments to up its ratings outlooks for Lithuania, Latvia and Estonia. The decision was apparently based on the idea that the contraction has been stabilized (which it has), but as we are unfortunately about to see, stabilization and getting back to growth are not one and the same thing. In Estonia's case the more favourable rating was a reflection of the expectation that the country "will soon be able to join the eurozone":

Estonia’s “economy and banking sector are exhibiting signs of a gradual recovery,” Kenneth Orchard, a Moody’s analyst in London, said. “Equally important, the government’s impressive fiscal performance in 2009 means that Estonia is likely to be permitted to adopt the euro next year.”

And if I'm reading this report aright, Latvia just declared a 9% general government fiscal deficit for 2009, well above the 6.7% which was originally estimated. Cry victory if you will, but perhaps it would be prudent to wait till the war is actually over before you cry it too loudly.

Too Soon To Cry "Victory" On Latvia?

2010-02-26T15:19:00.000+01:00

"Doom-mongers" - the Economist tells us - "are licking their wounds". And why exactly are they licking their wounds? Well for two years now (apparently) they have been telling us that "the struggle to save the lat’s peg to the euro was bound to end in tears". As you could imagine right in the very forefront of these so called doom-mongers is to be found yours very truly (and here), and of course Nobel Economist Paul Krugman (and here).

But while I have never thought of myself as especially adverse to admitting defeat when faced with compelling reasons to do so, just why, we might ask ouselves, should we start to think about licking our wounds right now (and why our wounds, since it is poor old Latvia which has been subjected to all the blood-letting implied by this none-too-convincing "thought experiment" turned reality)?

Well, in the first place, given the dramatic current account correction, Latvia's outlook has been revised from negative to stable by Standard and Poor's rating agency, which means - when you get down to the nitty gritty - that they don't expect any further downward revisions in Latvia's sovereign credit rating in the next six months.

Standard & Poor’s, a rating agency, has raised its outlook on Latvia’s debt from negative to stable (ie, it no longer expects further downgrades). The current account, in deficit to the tune of 27% of GDP in late 2006, is in surplus. Exports are recovering. Interest rates have plunged and debt spreads over German bonds have narrowed (see chart). Fraught negotiations with the IMF and the European Union have kept a €7.5 billion ($10 billion) bail-out on track, in return for spending cuts and tax rises worth a tenth of GDP.

And anyway, Latvia is not as bad as Greece.

Even so, Latvia looks good when compared with Greece. It did not lie about its public finances or use accounting tricks. Strikes have been scanty. Protests are fought in the courts, not the streets. Both Greece and Latvia have had hard knocks, but Greeks became used to a good life that they are loth to give up. Latvians remain glad just to be on the map.

As evidence for just how much better Latvia is doing than Greece the Economist cite the movements in the respective bond spreads, and of course, the extra interest the Greek government has to pay to raise money (with respect to equivalent German bonds) is now marginally more than the extra interest Latvia has to pay, but then Greece has yet to go to the IMF.

But just in case both these arguments seem rather like clutching at straws when compared to the "gravitas" of the situation, there is a "clincher".

"despite a fall in GDP last year of 17.5%, Latvia seems to have achieved
something many thought impossible: an internal devaluation. This meant regaining competitiveness not by currency depreciation but by deep cuts in wages and public spending. In a recent discussion of Greece, Jörg Asmussen, a German minister, praised Latvia for its self-discipline".

Well, I'm sure that having a positive reference from a German minister in a discussion on Greece is a positive sign, but hang on a minute: just what internal devaluation is our author talking about here, and what deep cuts in wages and salaries? According to the latest available data from the Latvian Statistics Office, average wages in Latvia were down 10% in September 2009 over 2008, but since wages in September 2008 were up 6.5% over wages in September 2007, when the Latvian economy was already in deep trouble and wages and prices were already seriously out of line, then they have only actually fallen back some 4.15% over the two year period. I am sure these cuts are painful (a 20% unemployment rate, and young people emigrating is even more painful), but I would hardly call this a "deep cut" yet awhile.

The thing to remember here is the difficult characterists imposed by the presence of a peg. Latvian real wages (when adjusted for inflation) may well have fallen more, but this is to no avail (and simply makes the internal consumption problem worse), since what matters are the Euro equivalent prices of Latvian wages and exports. This is one of the reasons why in these circumstances a peg is such a horrible thing.

And if you're still not very convinced, let's try the Eurostat equivalent data for average hourly wage costs, which had in fact only fallen by 3.5% year on year in the third quarter of 2009.

Why the difference between average wages and average hourly labour costs? Well, given the depth of the recession people are obviously earning less, since they are working less, but this doesn't help overall competitiveness, since what matters here is the hourly cost of each unit of labour. I'm sorry if this is all fairly turgid economic data stuff (yawn, yawn, yawn) but if you want to cry victory, you really do need to check your facts a bit first.

In fact, as I said in my last post, additional evidence from the consumer price index suggests the "internal devaluation" is only working at a hellishly slow pace. Prices were only down by 3.3% in January 2010 over January 2009 according to the latest HICP data from Eurostat.

And while producer prices have fallen a little further - by 6.6% in January over January 2009 - there is still a long long way to go.

Basically there is no doubt that Latvia's great economic fall may be coming to an end, but as I explained in this post here, that is not the same thing at all as resuming growth. To get back to growth Latvia's internal devaluation needs to be driven hard enough and deep enough to generate a sufficient export surplus to drive headline economic growth at a sufficient speed to start creating jobs again. This is not about a fiscal adjustment, it never was, and it is little consolation for Latvia to be compared with Greece and told that they are doing just that little bit better. Cry Victory we are told, and unlease the jobs of war. Would that things were as easy done as said!

Estonia's Economy "Only" Contracts By 9.4% in Q4 2009

2010-02-11T17:30:00.000+01:00

Hard on the heals of yesterday's Latvian GDP numbers we now have news that Estonia’s economy shrank at the slowest annual pace in a year at the end of 2009 as a modest recovery in exports and one-time stock-building helped offset the impact of the continuing decline in consumer spending. In fact gross domestic product fell 9.4 percent, which compares with a 15.6 percent drop in the third quarter, and a 16.1 percent decline in the second one. So the recession is evidently easing.

Indeed, startling as it may sound, the economy even grew during the quarter - by a seasonally adjusted 2.6 percent when compared with the third quarter. The news caused some surprise as even the Estonian Finance Ministry had been expecting worse results - an annual contraction of something in the region of 11 to 12 percent. The critical little detail is that the numbers were skewed, since they were affected by a one-off stock- building effect, according to the Finance Ministry, since companies built up their inventories in anticipation of a January tax increase on tobacco, alcohol and motor fuels. As the ministry also added, economic growth will thus see a “negative effect” in the first quarter of 2010 as inventories will inevitably be run down again.

"The alcohol, tobacco and motor fuel excises were applied in the beginning of the year, so the stocks of those products were increased, and that gave a positive move to the GDP in the fourth quarter, but will give a negative influence in the beginning of this year,” according to Andrus Sääsk Head of Macroeconomy at the Ministry of Finance.

No Sign Of Any Real Recovery

So, as we are seeing in the other Baltic States, the recession is gradually winding down, but there is no end to the agony in sight, since structural distortions in the economies produced by the earlier boom will impede any immediate recovery. If we look at retail sales the pattern is similar to what we are seeing elsewhere, and these are now down about 28% from their February 2008 peak.

A similar situation is to be observed in industrial output, which fell back again in December (by a seasonally adjusted 2.2% from November) according to statistics office data. Industrial output is now down 32.5% from the February 2008 peak.

And while exports have picked up slightly from the first quarter 2009 trough, momentum has not been strong enough yet to reverse the deadweight drag of domestic consumption.

The goods trade deficit has improved - indeed the 2009 deficit was the smallest since 1995 - but it is still a deficit, although the country does run a healthy services balance.

And the services balance is what makes the difference in turning the current account deficit into a surplus.

On the other hand unemployment continues to rise, and is the third highest in the European Union (after Latvia and Spain), hitting 15.2% in September - which is the last month for which the Eurostat has data at this point. Indeed statistics regularity and quality is one of the issues which Estonia will need to attend to as part of its general euro ambitions, as the ECB took the trouble to point out recently.

Demographic Issues Also Need To Be Addressed

Estonia's population fell again in 2009 - by 400 - and was estimated by the statistics office to be in the region of 1,340,000 at the end of the year. A falling death rate meant the population decline slowed down over the year, but the number of live births decreased for the first time in eight years (see chart below), raising issues about the longer term impact of the crisis. Some 15,807 live births were registered in total in 2009 - 221 birth less than in 2008.

While the situation is a lot less serious than the one Latvia faces, the downturn in Estonian births is a rather bitter blow for a country where fertility had rebounded substantially from earlier lows, and while the 1.6Tfr was still a long way from population replacement level, the improvement had been a welcome one.

Credit Rating Improvement

Estonia's credit rating outlook was raised this week by Standard & Poor’s, from negative to stable. More than the improvement, what is interesting is the reason given, since the agency cited improving prospects for euro adoption next year. This has both a positive and a negative reading. The positive reading is that S&Ps think Estonia will meet the eurozone membership criteria. The negative one is that the improvement is not due to any underlying change in the country's growth prospects, which are at the end of the day the main area of immediate concern.

Indeed S&Ps have an A- rating, the fourth-lowest investment grade, on Estonia and the move to stable from negative, means the rating is more likely to be left unchanged than raised or lowered. The rating was in fact cut from A last August, and evidently losing the A- rating would give a rather negative signal given that the ECB is about to return to at least one A- as the minimum collateral condition.

“Estonia has stabilized its public finances, which significantly increases its prospects for eurozone accession in 2011,” S&P’s Frankfurt-based Kai Stukenbrock and London-based Frank Gill said in a statement. The “outlook reflects our view of Estonia’s improving economic flexibility and the prospect of near-term eurozone accession against the challenges inherent in adapting the economy to lessen its reliance on external funds.”

Fitch currently has a BBB+ rating on Estonia, and the outlook on this was also raised to stable from negative on February 5. Moody’s Investors Service has an A1 rating on Estonia with a negative outlook.

Euro adoption terms require countries to maintain fiscal deficits below 3 percent of GDP, limit debt to 60 percent of GDP and ensure inflation isn’t more than 1.5 percentage points above the Eurozone average, and Estonia has met all the criteria, according to Prime Minister Ansip speaking yesterday. Whether Ansip's optimism is totally justified or not the EU Commission and the European Central Bank will publish their report assessing Estonia’s readiness to join sometime in May, and (assuming this is favourable) the Ecofin council of EU finance ministers will take the critical decision on entry on June 8.

But as Fitch pointed out when they raised their Estonia outlook, while eurozone membership looks increasingly possible it is not yet certain. Fitch warned in their report that even if Estonia meat all the formal Maastricht reference criteria for euro entry there is still a risk that the European authorities' interpretation of these same criteria could lead them to reject Estonia's application. According to Fitch, in Estonia's case uncertainty surrounded whether the idea of "sustainable price performance" was going to be consistent with the deflation which is to be expected from such a severe recession, after inflation had so recently been in the double digit range. The agency also added that one-off measures taken by the government to reduce the budget deficit in 2009 could also count against it in the EU authorities' judgment of whether the medium-term budget plans are credible.

The first point is an important one I think, and is reiterated by the ECB's own Jürgen Stark in an interview given to the German magazine Der Spiegel for this weekend: "But when taking on board new members, we will need to take an even closer look, concerning the data and the sustainability of convergence," he is quoted as saying.

Indeed if we go back to the 172 page EU Commission document leaked to the German magazine Der Spiegel last month, the EU Stability and Growth Pact is increasingly going to focus on issues surrounding competitiveness as well as on fiscal deficit ones. That is what the whole deabate over the Greek and Spanish economies which EU leaders are engaging in this week is all about. And any country which is not considered to be in completely good health under the SGP criteria is hardly likely to get the green light from the ECB and Ecofin.

It is obvious that the Estonian economy is still suffering from earlier structural distortions which have not yet been corrected. If we come to the consumer price index, this was only down about 2% in 2009, far short of the deflationary adjustment which will be needed to restore growth and competitiveness.

The producer price index has also not moved as far and as fast as will be needed, since it was only down some 3% on the year.

So the sad truth is that, whether from inside or outside the eurozone, despite some extensive and painful sacrifices made in not having government spending to fall back on during an extraordinarily deep recession - but then, as Krugman would say, Estonia's problems were never fiscal ones anyway, they were always competitiveness ones - there is still a long hard road out there in front. Whatever the advantages and disadvantages of the chosen path one thing is for sure, it will be absolutely impossible for the country to leave the job half done.

Latvia's Economy Contracts Almost 18 Percent in Q4 2009

2010-02-10T11:00:00.000+01:00

Well, as we say in English, it never rains but it pours. Latvia, which has had the deepest recession of all 27 European Union member states, contracted by nearly 18 per cent in the fourth quarter of 2009. 'Compared to the same period of 2008, gross domestic product (GDP) value has decreased by 17.7 per cent,' according to the national statistics office statement.

The fall was led by a 30-per-cent annual drop in the retail sector. Retail sales are now down by 36% from their April 2008 peak and there is little sign of any turnaround at this point.

Industrial output, which rose slightly over the quarter, fell back again in Deecember (by a seasonally adjusted 4.2%) following a sharp rise in November. Output is still down more than 17% from the February 2008 peak.

Latvian exports were down again in December, making for the second consecutive monthly fall. Despite all the fuss about internal devaluation the CPI was only down by 3.1% in January over January 2009. Prices are still far from being competitive, and no early rebound in export growth is to be expected. Over 2009 as a whole exports - at 3,571.6 mln lats – were down over 2008 by 19.4%, but imports - at 4,633.7 mln lats – fell even further, by 38.4% which is why the trade deficit reduced substantially, but note there was still adeficit. The deficit fell from 225.3 mln Lats in January to 69.7 mln Lats in December. Over 2009 as a whole foreign trade turnover totalled ay 8.2 billion lats, a drop of 31 per cent when compared to 2008.

Unemployment hit 22.8% in December according to Eurostat data, the highest in the European Union.

And even that famed "internal devaluation" seems to be working hellishly slowly. As I say, prices were only down by 3.1% in January 2010 over January 2009 (and probably even less on the EU HICP measure) according to the latest data from the Latvian statistics office.

Even the statistics office statement that GDP actually grew by 2.4 per cent compared to the third-quarter offers cold comfort, since this data is not seasonally adjusted, and the economy will almost certainly be back down again in the first quarter of 2010.

Meanwhile the consequences of this strong recession in Latvia - more and more Latvians are leaving in search of work elsewhere, while fewer and fewer young people feel confident enough to have children (see chart below) - will leave a long scar, which will be hard to heal, and which make the long term future and sustainability of the country even more uncertain.

As the Washington based CEPR argue "the depth of the recession and the difficulty of recovery are attributable in large part to the decision to maintain the country’s overvalued fixed exchange rate, because it prevents the government from pursuing the policies necessary to restore economic growth". Maybe next time someone will learn the lesson before tragedy strikes, and not afterwards.

Latvia Is Back In The News, And Expect More To Come

2009-12-24T11:25:00.000+01:00

The Latvian government is getting nervous about the level of lending coming from Swedish banks. According to the Financial Times, "Latvia’s prime minister has warned Swedish banks they risk choking off recovery in the Baltic state’s crisis-hit economy unless they resume lending". The Latvian authorities are complaining, it seems, that banks such as Swedbank and SEB, which dominate the Latvian market, have reined in credit as they struggle to contain rising bad loans amid the deepest recession in the European Union.

“The . . . abrupt stopping of credit is a very problematic issue,” said Valdis Dombrovskis, the prime minister. “We expect Swedish banks to start [lending] again. “Of course you can say that Latvians were borrowing irresponsibly but to borrow irresponsibly you need someone to lend irresponsibly,” he said. “We had very easy credit in a very overheated economy. Now we have almost no credit in a very deep recession.”

Well, here is some of the background. After an extended period when private credit was rising at nearly 60% a year, the Latvian credit bubble suddenly burst, with very unpleasant consequences for everyone. Since mid 2007 the annual rate of new credit has been falling rapidly, and turned negative in June this year. In fact total credit has been falling since October 2008.

Lending to households alone has also fallen back, after shooting up dramatically over several years.

And Latvian base money (M1) has also been falling.

In fact, and unsurprisingly (given that it is what we are seeing everywhere in the exploded bubble economies) the only sector which isn't deleveraging at this point is the government one.

So it seems hard to me to simply blame mean banks for not doing enough about a situation which many saw coming, but few were willing to do anything to avoid. Sure, the banks made a lot of bad decisions, but so did many other people, and each and every party is trying to extricate themselves from the mess as best they cab. In fact total Latvia debt is not in fact falling at this point in time, since while many individual Latvians have been frantically deleveraging, the government has been borrowing at a faster rate than ever, in part to bail out Parex bank, and in part to fund the ongoing fiscal deficit. In the meantime Latvian GDP has dropped sharply, falling back again in the third quarter at an even faster rate than in the second one. Which means that despite the fact that private indebtedness is falling, the level of private debt to GDP is still probably rising.

This unfortunate situation is only further reinforced by the fact that prices are falling - not too fast as yet, only an annual 1.4% in November, but they are falling, and they will fall further, and this means that the percentage of debt to GDP will again rise, and this is especially bad news for the Latvian government (even though the drop in prices is a desired objective, no win-win strategy left to use now) since any fall beyond that anticipated is likely to push up the total debt level of 60.4% of GDP currently being forecast by the EU Commission for 2011.

And the pain doesn't stop, since having cut 500 million lati ($1 billion) in spending in its 2009 supplementary budget, the government initially resisted the idea of finding an additional 500 million lati of savings in the 2010 budget arguing that with no policy change the deficit was expected to be lower than the 8.5 percent target. Valdis Dombrovskis said in October his government could cut only 325 million lati in the 2010 budget and still meet the 8.5 percent target agreed with international lenders. The lenders did not agree, and Swedish Premier Fredrik Reinfeldt even intervened to tell Latvia it “must correct” its deficit. Following the rebuke further measures were passed equal to 500 million lati for 2010, and the country now targets a deficit of 7.6 percent of GDP. This is to be followed by a budget deficit target of 6 percent of gross domestic product in 2011, in order to finally arrive at the magic number of 3 percent deficit in 2012.

But considerable doubt exists over the ability of the Latvian authorities to fulfil these objectives. Which is why Mark Griffiths, IMF mission head in Latvia, describes the situation facing the government as challenging, and why the EU Commission base their Autumn forecasts on much higher deficit levels. The problem is that with domestic prive deflation (which is, remember, what Latvia is aiming for, the so called "internal devaluation" what is called nominal GDP (that is current price, unadjusted GDP) is likely to fall faster that the so called "real" GDP (adjusted for inflation) and this has two very undersireable consequences. In the first place debt to GDP goes up even faster, and the revenue which government receives (which is based on actual prices) drops faster than GDP, causing more instability in public finances. The deflator has shown falling prices since early this year and the EU commission is forecasting a drop of 5% for 2010.

So basically, in this climate, with unemployment rising, and wages falling, and an economy contracting at nearly 20% a year, it isn't hard to understand why not that much new bank lending is going on. Those who are creditworthy are trying hard to save, while those who need to borrow normally aren't that creditworthy, so Dombrovskis' plea is rather like asking the bank to subsidise new bad debts, and that is really not something you can do, and especially not when you are going along the course you are following because you wanted to, and against one hell of a lot of external advice. What kicked the whole process off was a short sharp credit crunch, but now it is the contraction in the real economy which is following its own dynamic, till someone finds a way to put a stop to it. It is the drop in output that is preventing banks from lending, and not banks being unwilling to lend that is causing the contraction to continue.

But there is another point in the FT article which should give food for thought.

Mr Dombrovskis...ruled out devaluation of the lat. While breaking the currency’s fixed exchange rate with the euro would help Latvia’s exporters, it would increase the burden of euro-denominated loans, which account for 85 per cent of lending, he said.

“We would not see much benefit from devaluation because we are a very small and open economy which means that any competitiveness gains we may get would be very short-lived,” he said. “We would redistribute wealth from pretty much all the population to a few exporters.”

Well, we haven't advanced too far in all these months, now have we, if we are still wheeling out the argument that "external" devaluation will hit holders of euro denominated loans, since it should be generally recognised that the (very painful) internal devaluation which is now taking place is hitting Euro loan and Lati loan holders alike. And the argument is a strange one to use just shortly after the statistics office announced that due to the rapid reduction in the number of those employed and to the fact that many of them changed their working conditions from full-time to part-time, the number of hours worked in the 3rd quarter of 2009 fell by an annual 27.3%, while labour costs fell during the same time period by 30.1%. This fall in disposable income, and the continuing prolongation thereof, poses a far greater threat to the continuity of Latvian loan payments than the 15% reduction in the value of the Lat as compared to the Euro which the IMF proposed in the autum of last year would have done. Indeed, it is, in and of itself, one of the pernicious consequences of having resigned yourself to an "L" shape non-recovery. Stress on the banking system only goes up and up, as incomes and employment fall, and the government has less and less ammunition left to counteract the contractionary pressure.

It is like sitting it out in freezing weather at the North Pole, in the vain hope that help will arrive. But help will not arrive, and the cruel truth about the post-crisis shock world we live in, is that nobody is coming to help you if you will not help yourself. In this sense, what Latvia doesn't need is more international borrowing (hasn't there been enough of that already) but some kind of meaningful strategy to start paying back the debt. But this means putting people back to work, and selling abroad, and financing Latvian lending from Latvian savings, and not pleading for yet more capital inflows to finance non-productive activities (attracting investment would be another matter, but as things stand right now the environment is far from "appetising", and according to the latest data from the Statistics Office, non-financial investment in Latvia was only 402.8 mln lats in the third quarter, a fall of 39% on the 3rd quarter of 2008).

And just to be clear, what we have seen to date is not a 30% drop in unit labour costs (which would, of course, mean a great boost to competitiveness), rather it is a drop in earnings due to the fact that the output people could have produced just isn't needed, since no one is willing and able to buy it. In fact according to the data of the Statistics Office to hourly labour costs fell by only 3.9% in the 3rd quarter when compared with the same period a year earlier. Hardly a massive drop, and especially not when the large annual increases of ealier quarters are taken into account (see chart below). The internal devaluation has a long course still to run!

Pensions Dilemma

But Latvia is back in the news today for more reasons, since the constitutional court has just ruled against the government pension cuts, drawing a question mark over Latvia's ability to meet the terms of its international lending commitments.

"The decision to cut pensions violated the individual's right to social security and the principle of the rule of law," the court said in its judgement, which cannot be appealed. The pension cuts - in place since July - formed a vital part of the Latvian government's list of austerity measures, as it struggles comply with terms of the IMF-lead bailout, and the constitutional inability to implement them is another hammer blow against the credibility of the current Latvian administration.

According to the Baltic Course, Valdis Dombrovskis told Latvian State Radio that the Constitutional Court's ruling on pensions must be carried out, and not debated. I am sure this will really come as music to the ears of people in Brussels and Washington. Basically pension reform forms a key part of the mid term strategy for sustainability of Latvian finances, and without the ability of the Latvian government to carry these out, then frankly the coherence of the whole strategy falls apart. If the Latvian constitution does not permit pension changes, then the Latvian constitution has to be changed, and the only surprising thing is that all this wasn't forseen when the initial loan negotiations took place in late 2008. Basically, it is impossible for the EU Commission and the IMF to accept any other view, since if any state could ring fence a whole part of social provision before entering debt negotiations, then non of the structural reform programmes could possibly work. This may seem harsh, but it is the price you have to pay for becoming insolvent as a society. Latvia's problems are NOT short term liquidity ones, but problems of the sustainability of an entire economic and demographic model, and, as in the case of Greece, these problems will not be solved by two or three years of (rather painful) fiscal deficit cosmetics. Real changes need to be made, and especially in raising the long term growth potential of the country, and frankly it is these changes which we have yet to see evidence for.

The issue is not simply one of limping into the Euro in 2012, even if as Mark Griffiths, the IMF’s mission head in Latvia, said in Riga last week the Latvian government does face a lot of “hard work” in trimming the budget deficit enough to qualify for euro adoption, and how much more so if they cannot constitutionally implement the cuts they agree to.

“The key is meeting the deficit targets, and meeting the Maastricht criteria and euro adoption, that’s the path,” Griffiths said. “The government needs to work hard over the next year to find the measures which will deliver that adjustment to meet those targets. It’s going to be a challenging task.”

Oh yes, and Latvia was also in the news yesterday for another reason, since Latvian stocks dropped the most among equity markets worldwide as small investors sold stocks before the government starts to tax investment gains. The OMX Riga Index fell as much as 4.3 percent to 271.55, its lowest intraday level since August 21. In dollar terms, the drop was the biggest among 90 benchmark indexes tracked by Bloomberg. The reason for the sell off was that Latvia’s 2010 budget includes measures which will impose taxes on dividends, gains from trading stocks and bonds and interest income. These measures were agreed to in order to ensure the continued transfer of the 7.5 billion-euro bailout from the European Commission and the International Monetary Fund.

Latvian investors have increasingly sold their holdings ahead of the Dec. 31 deadline. Dividends and interest income will be taxed at 10 percent, while tax on gains from trading stocks and bonds will be 15 percent.

As Unemployment Climbs, Latvians Start To Pack Their Bags

Finally one that wasn't in the news, but should have been, since while everyone knows that at 20.3% Latvia's unemployment is the highest in the European Union (see chart below), what they don't know is that more Latvian's than even are now being forced to leave their country in search of work.

According to a report by Oļegs Krasnopjorovs, economist with the Bank of Latvia, during the first half of 2009 8,300 Latvian residents left for Great Britain, a twofold increase over the year earlier period. 3,600 people emigrated to crisis-ridden Ireland in the first 11 months of 2009 - 3% more year-on-year. Among the new EU member states, Latvia has seen the sharpest increase in emigration to these two countries.

According to Krasnopjorovs, the data (which comes from the UK and Irish social security systems) confirm the trend identified by the Latvian Statistics Office, who examined data on long-term migration. In the first ten months of 2009, the number of long-term emigrants was 6,300, up 18% more year-on-year; moreover the steepest rise took place in the last few months, reaching a ten-year peak. For several years now the number of emigrants has exceeded that of immigrants in Latvia, with the exception of the second half of 2007 when a sharp rise in salaries and a steep drop in unemployment were fuelled by the credit and construction boom, leading to labour force shortages and the expectation that incomes would rise even further.

Exports Still The Key

The real problem here, of course, is that the Latvian economy remains mired in deep recession, and shows few signs of real recovery, something which is not surprising given that domestic consumption is in limbo land (where it is likely to stay), while the Prime Minister seems to attach little priority to boosting exports, and regaining competitiveness. Indeed, the contraction has rather gathered than lost momentum in recent months, and on a seasonally adjusted basis Latvian GDP fell another 4% between the second and third quarters of 2009. This was much faster than the 0.2% contraction between Q1 and Q2.

Year on year Latvian GDP fell by 19.0% in the third quarter.The decrease was largely due to a 28.7% drop in external trade (share in GDP 15.6%), a 18.2% one in transport and communications (12.5% GDP share), an 17.4% fall in manufacturing (10.2% GDP share, incredible) and by a 36% drop in construction (7.5% GDP share, not far below manufacturing).

Private final consumption fell by 28.1%. Government final consumption decreased by 12.4%, while expenditure on gross capital formation fell 39.4%. Goods exports (68.2% of total exports) fell by 11.7% and services exports by 20.5%. Goods imports (82.1 % of total imports) were down much more sharply - by 36.6% -and services imports by 29.1%. Which meant net trade was positive, otherwise the fall in GDP would have been greater, and nearer to the levels seen in domestic demand.

And entering the fourth quarter there were few signs of any real improvement. Retail sales fell in October by 1.3% from September (on a seasonally adjusted, constant price basis).

As compared to October 2008 sales were down by 29.1%. The drop was even larger in the non-food product group – 32.3%. According to Eurostat data, sales are now down nearly 35% from their April 2008 peak.

Industrial output, however, seems to be holding up a little better, and output has stabilised since the spring. The problem is that manufacturing industry is now such a small share in GDP that it will be hard to pull the entire economy on the basis of anything other than very strong rates of increase. Industrial production was up in October by 0.1% over September, marginal, but at least it wasn't a fall. Unfortunately most of the increase was in the energy sector, with electricity and gas up by 10.3%, mining and quarrying contracted, by 2.1% as did manufacturing, by 1.9%.

Compared to October 2008 industrial output was down by 13.5%, Output in manufacturing fell by 15.8%, in mining and quarrying by 11%, while in electricity and gas output was only down by 2%. Output is now down around 21% since the February 2008 peak.

There is one positive glimmer on the Latvian horizon at the present time, and that is, of course, exports which were up by more than 4.4% (or 31.7 mln lats) when compared with September.

As a result, the surplus in the current account of Latvia's balance of payments reached 10.1% of gross domestic product (or LVL 327.9 million) in the third quarter. The surplus is however rather smaller than in the second quarter, which was 14.2% of GDP.

With export growth exceeding that of imports, the combined goods and services balance was positive for the second consecutive quarter, standing at 0.3% of GDP (or LVL 11.2 million). This effect is more due to services than to goods exports, since the goods trade balance is still in deficit (see chart), so there is still a long road to travel.

The largest third quarter capital inflows registered under the capital and financial account were the result of government borrowing from the IMF-lead support programme. There was some new foreign direct investment in Latvian companies to the amount of LVL 370.2 million, which to some extent offset direct investment outflows. Net external debt shrank by LVL 0.5 billion in nominal terms, but due to the fall in GDP (as I explained earlier) the ratio of net external debt to GDP posted only a tiny drop, reaching 56.4%, and gross external debt to GDP (excluding foreign assets) was up, reaching 145.8%.

So, as I say, a start has been made, even if there is still a long, long road to travel. Internal devaluation is the chosen path of the Latvian people, the best thing I can suggest at this point is to get it moving in earnest (in fact there is some evidence from November producer prices that the rate of price fall is now accelerating), and that Latvia's leaders start to value what they have (that is, export potential) instead of dreaming of what they can no longer have (dynamic domestic consumption driving growth). Living in the past is never a good idea, not even in the sentimental moments of Yuletide. A Merry Xmas to you all!

Latvia's Agony Continues In The Second Quarter - With Little Relief In Sight

2009-09-09T13:30:00.000+02:00

Latvia’s economy shrank a revised 18.7 percent in the second quarter of 2009 over a year earlier in what was the second-steepest drop in the entire European Union (worsted only by Lithuania) according to detailed data released by the statistics office yesterday. The contraction, which is now the largest since quarterly records began in 1995, was revised down from a preliminary estimate of a 19.6 percent annual drop. And Latvia's problem can easily be seen in the above charts which show the most recent movement in exports, and quarterly data for constant price imports and exports. The Latvian economy grew driven by domestic consumption and increased borrowing during 2006 and most of 2007, but then the country ran out of extra sources of cash, and so imports slumped, followed by exports as the global economy entered crisis. Now its time to pay back, which means the lines we see in 2006 and 2007 will now need to be repeated, only this time with exports on the top and imports below. Of course, really doing this will only be possible once the global economy recovers. But the key question is, will Latvian export capacity be ready when that critical moment comes, or will Latvia's agony continue, stuck in a horrid "L" shaped "non-recovery"? The most recent data on foreign trade, which saw exports fall and the trade deficit once more widen suggest that the latter danger is far from being a mere theoretical one.

And I am not the only one to be raising it, since according to the latest report out from Nordea Bank, Estonia, Latvia and Lithuania, may well suffer deeper economic contractions than previously estimated as government austerity measures simply serves to sap domestic demand while export growth remains muted.

So well done Nordea! But please permit me to say that this discovery does come as a bit rich from analysts who have persistently remained in denial that the key to Latvia's recovery was a substantial reduction in the price level in order to facilitate exports (on my view better achieved by formal devaluation, but by the express desire of the elected political leaders of the Latvian people now being carried out via a convoluted and painful process known as "internal devlauation").

Still, it is interesting to see mainstream analysts starting to question the current orthodoxy that fiscal prudency will (due to the impact on investor confidence) lead to recovery in Eastern Europe, while here in the West our leaders have just re-affirmed the need to maintain fiscal stimulus, given the fragility of even those earliest signs of recovery.

Indeed the analyst consensus is becoming more and more pessimistic. Danske Bank say the following in their latest Emerging Markets report:

"Worries over Latvia’s public finances continue. Despite aggressive cuts in public spending so far this year, total central government spending in August 2009 was, extraordinarily, exactly the same as in August 2008. This is partly due to spending cuts being offset by increased social spending, and partly to some ministries and agencies awarding their employees big pay increases in June this year before imposing cuts in July as part of the IMF/EU programme. It is still too early to say that everything is fine in the state of Latvia."

In the following monthly report I will examine just what evidence there is for the idea that Latvia's economy has actually bottomed out.

The Fall In GDP Continues

Latvia’s economy shrank an annual 18.7 percent last quarter, following a drop in gross domestic product of 18 percent in the first quarter. The charge downwards was lead by a decrease in private final consumption which fell an annual 23.21% (year on year - see chart). Government final consumption dropped bya mere 6.9%, but expenditure on gross capital formation (which includes the critical investment item) crashed by 38.1% - with construction (which forms part) down 29.5% (see chart below). Goods exports (63.6% of total exports) was down by 19.1% and the export of services by 15.7%. The slump in imports was, of course) even worse with the volume of goods imports (78.8% of total imports) down 39.4%, and the volume of services imports by 38.2%.

But Slows On A Quarterly Basis

Quarter on quarter, however, the rate of contraction did slow slowed substantially, from an 11% rate in the first quarter to a 1.6% rate in the second quarter. But even though the rate of contraction is now much, much slower, the economy is still contracting, so I think it is not quite accurate to say we have hit bottom yet. And hitting bottom is not the same as recovering, since there is unlikely to be any rapid bounce back, and any "recovery" is likely to have an "L" shape with a slight upward slope.

Meanwhile, and hardly surprisingly, during the month Latvia’s credit rating was lowered by Standard & Poor’s, with the long-term foreign currency rating being lowered to BB, two notches below investment grade, from BB+, with a negative outlook. According to S&P's:

“The rating action reflects our view of the political and economic challenges as a result of rapidly contracting nominal and real incomes and the associated pressures on public finances, as the country struggles to improve its growth prospects while maintaining a fixed exchange rate regime.....The outlook for growth beyond that remains highly uncertain, not least due to highly leveraged household balance sheets.”

S&P's estimate that Latvia’s general government debt, which stood at 19 percent of GDP last year, will grow to over 80 percent in 2011, an estime which is broadly in line with current EU Comission forecasts.

The International Monetary Fund also agreed on August 27 to disburse the second installment (of around 200 million euros) of the 1.7 billion-euro credit line approved last December. The decision followed a long period of uncretainty. Latvia’s government is trying to cut spending/or raise revenue by 500 million lati ($1 billion) a year between now and 2012, in a bid to get the budget deficit below 3 percent of GDP as part of an attempt to meet euro adoption criteria.

The IMF said in their statement that the program had been adjusted to reflect:

- a significant increase in the program’s fiscal deficit ceiling in 2009 (up to
13 percent of GDP, compared with 5 percent in the original program) to avoid
measures that would harm the most vulnerable, and

- an allowance of 1
percent of GDP in additional resources for social safety nets.

The statement which Moody's following the IMF decision asserting that Latvia’s Baa3 government bond rating - the lowest investment grade, - was being kept at stable was hardly surprising, although the justification they gave - that the bond issuance was supported by “significant, extraordinary fiscal assistance” from international lenders - surely was significant, and very much to the point. The EU Commission and the IMF are now guaranteeing and in order to do this have effectively assumed sovereign responsibility fo the country (see Appendix below).

Moody's were also a little more optimistic than S&Ps on government debt, since they estimated it would only rise to about 60 percent of gross domestic product in 2010 and fluctuate from about 60 percent to 65 percent over the medium term. I think this is too optimistic, basically for the sort of reasons S&Ps are giving. On the other hand they did also state that a currency devaluation, while not being their central scenario, "was a clear risk, along with additional problems in the banking sector".

Little Sign Of Any Recovery In Main Indicators

If we now come to the future, we have to note there is little hard evidence at this point for any real recovery - nor should we expect to see any. Industrial output is still falling, and was down 1.4 percent in July over June, and 17.7% year-on-year (over July 2008). This compared with a 18.5% annual fall in the previous month.

Latvia's industrial output started falling in February 2008, and has now fallen 22.4% from it peak.

Retail sales were down 1% in July over June, and 29.5% over July 2008.

Retail sales have now been falling since April 2008, and are now 31.18% below their peak.

The Trade Defict Widens in July As Exports Drop Back

Latvia's July trade deficit was 95.2 million Lati up from 67 million Lati in June. This was the first increase since December 2008. Latvian foreign trade turnover came in at 613.3 mln lats in July, down by 3.8% or 24.5 mln lats in current price terms than a month earlier and and down by 41.1% over July last year.

In the January – July 2009 period foreign trade turnover was 4517.6 mln lats – down by 36.1% or 2547.5 mln lats over the same period in 2008.

In July exports were down by 32.6% over July 2008 and imports down 46%. Over January to July exports were down by 27.2% or 705.4 mln lats, while imports were down by 41.2% or 1842.1 mln lats over the same period a year ago.

Unemployment Continues To Rise, And As It Does Bad Loans Pile Up In the Banking Sector

Latvia's unemployment rate hit 17.4% in July according to Eurostat data, and again this was the second highest level in the European Union (after Spain). Naturally with unemployment rising to such levels the number of distressed loans continues to rise and bad debt provisions in the banking sector wnet up again - to 6.6 percent of the total credit portfolio in July from 6.1 percent the month before, according to credit supervisor FKTK.

The FKTK also said in a statement that bank losses by the end of the first seven months had hit 400 million lats ($817.6 million), up from 346.8 million lats at the end of the first half.

Lending was again down, and the total credit portfolio fell by 0.7 percent in July. The level of debts with delayed payments of more than 90 days rose to 13 percent of the credit portfolio from 12 percent at the end of June.

What About The Internal Devaluation, Is It Working?

Well, prices have started falling, and the consumer price level was down in August by 1.0% compared to July. The average prices of goods fell by 1.3%, and of services by 0.4%. But if we compared to August 2008 we find that consumer prices (as measured on the Latvian national index) have incredibly still increased by 1.8% (down admitdely from the 2.5% rate of increase in July), which leads me to ask, given the pain that all of this is evidently causing, are prices still falling too little and too late to do any real good.

The central bank seems to think the process is working, since they point out on their website that the real effective exchange rate of the lat, which is one measure of the price competitiveness of Latvian goods versus those of the country's major trading partners, improved between April and July, marking the first four-month gain since the beginning of 2005. We need to remember howvere that the REER index showed prices developing far faster than trading partners all the way from 2006 through to April 2009 (see comparative chart with Finland below) so there really is a long long way back down to go. And if we look at the chart immmediately below, we will see that while the gap is closing Latvian prices are still in a worse position in August 2009 (as compared to other Eurozone countries) than they were in August 2008 - that is over the last year as a whole the position has even deteriorated.

A similar picture can be found in producer (factory gate) prices, which have only recently moved into negative territory on an annual basis. To get a comparison, German producer prices were down 7.8% year on year in July, while

In fact, while export prices are dropping substantially, import prices are also falling (see chart), and thus the real rate of price correction is still quite small.

I therefore contend that this weeks statement from Unicredit Group Chief Economist Marco Annunziata to the effect that, “For the region as a whole and for Latvia, we have gone through the worst,” is way too premature. Conditions are not improving, and as Moody's suggested pressures in the banking system are still building up. It is an open empirical question at this point whether we have the worst behind us. Even over a longer term horizon it is hard to see the grounds for optimism, since there are certainly no "green sprouts" to be seen on the new babies front, with year on year three month moving average being stuck around the 8% drop level. This depression is going to cast a long shadow over the future of the Latvian people, let's hope for everyone's sake that all those responsible (the government, the IMF, and the EU Commission) are fully aware of their hsitoric responsibilities here.

Appendix: IMF and EU Conditions from the respective Letters of Intent.

According to the letter of intent signed by the Latvian Government, The Central Bank and the IMF, a number of new reporting obligations were agreed to. These include:

* Consolidated central (basic and special budgets), local and general government operations based on the IMF fiscal template
* Detailed information on revenues from EU funds at the general government level, and EU-related spending by the central government, including transfers to local governments for EU-related spending
* Consolidated central and general government bank restructuring operations
* Privatization receipts received by the general government budget (in lats and foreign exchange, and payments in governments bonds)
* Information on debt stocks and flows, domestic and external (concessional and non concessional), by currency, and guarantees issued by the (i) consolidated central, local and general governments and (ii) public enterprises (including the Latvian guarantee agency and
the Rural guarantee fund), including amounts and beneficiaries
* Information on new contingent liabilities, domestic and external, of the consolidated central, local and general governments
* Data on general government arrears, including to suppliers
* Data on operations of extrabudgetary funds
* Data on the stock of the general government system external arrears
* Balance sheet of the BoL, including (at actual exchange rate) (i) data on components of program NIR; (ii) government balances at the BoL, broken into foreign exchange balances—distinguishing various program partner sub-accounts for program financing—and balances in lats.
* Balance sheet of the BoL (in program and actual exchange rates) (i) data on components of program NIR; (ii) government balances at the BoL, broken into foreign exchange balances—distinguishing various program partner sub-accounts for program financing—and balances in lats.
* Consolidated accounts of the commercial banks
* Monetary survey
* Currency operations, including government foreign receipts and payments and breakdown of interbank market operations by currencies (interventions)
* Aggregated data on free collateral—available, unpledged collateral held at the Bank of Latvia
* Daily data with banks’ current accounts, minimum reserve requirements, stock of repos and fx swaps
* Foreign exchange rate data
* Volume of foreign exchange lats trades
* Projections for external payments of the banking sector falling due in the next four quarters, interest and amortization (for medium and long-term loans)
* Projections for external payments of the corporate sector falling due in the next four quarters interest and amortization (for medium and long-term loans)
* The stock of external debt for both public and private sector

The Letter of Intent follows the earlier signing of a Supplementary Memorandum of Understanding between the Latvian government and the European Union. The terms of this understanding contained the following Monitoring and Reporting protocols.

Monitoring fiscal developments

• Monthly revenue and expenditure break-down of social budget, including data on social
benefits' hand-outs (unemployment, family, etc).
• Monthly state basic budget expenditure breakdown per type of expenditure for each
ministry or other relevant budget entity.
• Monthly revenue and expenditure break-down of local governments, including data on
GMI hand-outs and other benefits included in category "other social support".
• Monthly information on debt stocks and flows and guarantees given on new debt,
contracted by the (i) consolidated central, local and general governments and (ii) public
enterprises.
• Monthly data on new contingent liabilities of the consolidated central, local and general
governments.
• Monthly data on state budget loans and PPP projects.
• Monthly information on central government (i.e., ministries and agencies) and state
owned companies' staff and remuneration levels, institution-by-institution, showing last
months'/years' trends.
• Monthly data on general government arrears, including to suppliers.
• Bi-weekly Treasury cash-flow assessment of central government financing needs.

Monitoring financial developments

• Monthly statements of the operations on the special account.
• Monthly report on the amount of mortgage loans converted from EUR to LVL.
• Monthly report on outstanding loans split by currency and detailed to households
(housing, consumer, other) and non-financial corporations (by sector).
• Notify DG ECFIN whenever there is a consultation process with DG COMP related to
financial sector stabilization (i.e., Parex).
• Monthly report on banking sector stabilization measures.

Monitoring structural reforms

• Monthly data on budget allocations to and appropriations of line ministries for financing
of EU Structural funds and Cohesion fund projects (including which programming
period they are related to).
• Monthly data on the amounts disbursed to final beneficiaries for project
implementation, by ministry and by EU Structural funds and Cohesion fund projects
(including which programming period they are related to).
• Monthly data on the amounts spent by state budget financed entities as final
beneficiaries on EU Structural funds and Cohesion fund project implementation, by
ministry and by EU fund (including which programming period they are related to).
• Monthly financial reports on reaching the Structural Funds and Cohesion Fund
expenditure targets by the Managing Authority.
• Quarterly qualitative assessment reports on reaching the Structural Funds and Cohesion
Fund expenditure targets by the Managing Authority.
• Quarterly assessment of policy options taken by the government regarding poverty,
health and pensions.

Is It Hot In Latvia In August?

2009-07-29T11:36:00.000+02:00

Well the big news this morning is that the IMF mission to Latvia has finally reached agreement with the Latvian government on a new policy package that will give the country access to about $278 million in new financing. Details of the deal are scant at the moment, since the Letter of Intent will not be published until the IMF board approves the agreement, but it seems the terms of the IMF deal are (on the face of it) tough: additional budget cuts worth a reported 500 million lats ($1.02 billion) for 2010, a progressive income tax with the possibility of an increase in VAT if the cuts do not reduce the budget deficit to the stipulated level.

Really, this agreement changes very little in my opinion. As Capital Economics' Neil Shearing points out, many people are assuming that with the rapid Current Account adjustment in many CEE countries, the threat to external financial stability has largely gone away. But as Neil argues, while theoretically, it should be enough for the countries just to move back to balance, practical experience from Argentina etc suggests that as recovery arrives the CA tends to move from large deficit to large surplus. And this of course means exports growing at a much faster rate than imports. This is the only practical way to pay down the debt.

And as Afoe's own Claus Vistesen puts it:

This is all about the composition of the external balance and what kind of extensions foreign creditors give. Now, the benefit of the peg is of course that you can begin to accumulate foreign assets at reasonable valuation to your liabilities. HOWEVER, the only way to reasonably begin this process is of course to actually begin accumulating those assets and in order to so so, you need productive investment targeted at foreign operations and this is very difficult unless the "internal devaluation" has run its course. Essentially, domestic investment to serve foreign markets are not productive until deflation has taken its toll.

So basically the message is, whatever the final details of the new agreement, stay tuned and keep watching, since all of this is far from over.

Edward Will Not Be Going To Latvia In August

The little news of the day is that I will not be attending the conference on Latvia's economic future which members of the Peoples Party are trying to organise for August, even though I was invited. As the Latvia Daily Diena (Latvian only I'm afraid) which reports on the preparations for the conference puts it "E. Hugh, who declared himself a defender of the lat devaluation, however, declined to participate, adding he'd like to maintain political neutrality." Well, this is fair enough as a presentation of my opinion, but, just for the record, here's what I actually did say.

First of all I would like to say thank you very much for thinking of me and inviting me to your conference....

....while I think a decision to accept the original IMF proposal of a 15% devaluation of the Lat, and pressure the EU Commission into euro entry was the best option last autumn, this is now no longer the situation. So while I was advocating devaluation back then, what I am saying now is that in my opinion devaluation is inevitable at some point, but that it will now be an unholy mess. Serious contagion problems will most likely ensue, and so in this sense I am no longer "advocating" Latvian devaluation. Ideally it needs to take place as part of a much more general solution to problems in the economies of the Eastern European countries who are members of the EU.

If Latvia is simply forced off the peg, then we should all watch out. I am in Spain, and I am expecting consequences here.

Thirdly, I am not in basic disagreement with the IMF, and would not wish to do anything which may make their work more difficult. Basically, from where I am sitting the issue is to put pressure on the EU institutional structure in an attempt to get them to recognise some of the basic ABCs of economics.

Lastly, I would emphasise that I am an economist, a mere technician of economic systems, and not a politician. I am explicitly non politicial, and am maintaining this stance both vigourously and adamantly.

Basically, as I said, I consider devaluation inevitable..... tomorrow, in August, after Christmas, in 2011, I don't know when. I also know that the longer it is in coming, the more serious the consequences will be, due to the continuous degradation in the credibility of the associated institutions (IMF, ECB, EU Commission, EBRD etc). This is all now quite likely to eventually become (via the other Baltic states, Bulgaria, Hungary, Romania and even Ukraine and Serbia) a very serious problem, with potentially major global implications.

So there will be a before and after. After devaluation there will need to be a major rethink about where Latvia is going. Devaluation is not an end in itself, it is simply a means to an end, a begininning. We also need to think about how Latvia will earn its living, pay off its debts, and find its way in the world.

Long term structural, and strategic economic thinking are needed.

Here I think I do have a part to play. As you may well have noticed, my view is that the ongoing demographic deterioration of your country lies at the heart of your macro economic problems.

I think this deterioration needs to be addressed as soon as possible, and I see three large issue.

i) Productive capacity needs to be increased substantially. This means increasing the labour force, and this means (as outlined in the World Bank Report, From Red To Grey) facilitating large scale inward migration. Given the serious political implications of encouraging ethnic Russian migration into your country, I see only two viable source regions, the Central Asian Republics in the CIS, and Sub. Saharan Africa. Possibly this solution will not be widely popular with Latvian voters. Well, they do have the right to choose. Your country can take the measures needed to become sustainable, or you can watch it die, as the economy shrinks, and the young people leave. That, I think, is your choice.

The other two measures you need to take are contingent on the first being implemented, since without the first measure you will simply not dispose of the economic resources for the other two.

ii) A serious policy to support those Latvian women who do wish to have children. But with major financial advantages, not half measures, and propaganda stunts. You need policies that can work, and I know plenty of demographers with ideas.But this needs money. Important quantities of money. And gender empowerment, right across the economy, at every level. We have formal legal equality in the labour market, but evident biological and reproductive inequality, in that only one of the parties gets to bear the children. The institutional resources of the state need to redress this imbalance.

iii) Major reforms in the health system to address the underlying male life expectancy problem. You can only seriously hope to raise the labour force participation rates at 65 and over if people arrive at these ages in a fundamentally healthy condition. In economic terms, simple investment theory shows why this is the case. A given society spends a given quantity of resources on producing a given number of children, those who have citizens who live and work longer evidently get a better return on their investment. If you want to raise Latvian living standards, you have to raise the life expectancy. And this apart from the evident human issues.

OK, I am saying no for the moment, but I would like to stress that when conditions change, I would be more than willing to come to your country to try to help. But not for a day, for a month, and not to give a talk, but to work with some serious people who are willing to roll their sleeves up and do the serious spadework that will be needed to find those solutions you so badly need.

Basically, my feeling is that the issues you face are so complex that public debate is unlikely to produce a very fruitful outcome at this point. You need a long term education process, and for the time being more or less technocratic solutions, but not the technocratic solutions you are being offered by the EU now (which basically won't work), technocratic solutions which get to the heart of the problem and set your country on a sustainable path.

It Isn't Only Canicular Heat They Are Suffering From In Latvia

2009-07-24T00:22:00.000+02:00

Maintaining the peg also requires substantial political commitment. If this commitment were to falter, there is a risk that the execution of the difficult but necessary policies required under the authorities’ program could also weaken. However, all political parties are strongly committed to the exchange rate peg.

How the world changes in six months. The above lines come from the IMF "Republic of Latvia: Request for Stand-By Arrangement - Staff Report" of January 9 2009. But just today we can read in a Baltic newspaper:

"Reliable sources tell LETA that the International Monetary Fund (IMF) has stipulated that the loan agreement document must be signed by all ruling coalition parties in Latvia, thereby showing their resolve to implement it."

The reason the IMF are now so edgy is spelled out by Reuters Political Risk Correspondent Peter Apps:

A string of other countries are also facing stark cuts, and analysts say in many - like Latvia - domestic politics could well intervene as elected politicians are unwilling to face the political consequences of cuts demanded by the IMF and wider financial markets.

So what the IMF are evidently worried about is the possibility that some coalition members may support the agreed measures just long enough to get the payout, and then effectively disown them. This seems to be a far cry from the substantial political commitment that was earlier considered to be so essential to maintaining the peg.

And the issue goes well beyond Latvia, since as Apps points out, a string of other countries are in a similar if currently marginally better condition, including Bulgaria, Romania, Lithuanis and Hungary, all busily making cuts while coming to rely more and more on multilateral lenders.

So if there is no clear resolution to Latvia's growing dispute with the IMF, the European Union could end up facing a dilemma - whether to bail out troubled emerging European countries who won't make cuts or face the consequences of not doing so. As Lars Christensen, head of emerging markets research at Danske Bank in Copenhagen says:

"This could be a test case for Europe....In Latvia, it's domestic politics that really become the driver. The question is what the EU would do if the IMF walks away."

A good question.

In the above quoted IMF document, they also make the following point:

Correcting currency misalignment without nominal depreciation is extremely difficult, as experience from other currency board and fixed exchange rate countries continues to show. Large external financial support and sustained wage and fiscal discipline by both the private and public sectors are required. Failure could entail substantial reputational risks for both the authorities and international institutions.

The last sentance is important, failure could entail substantial reputational risks for the international institutions involved, in particular in this case for the IMF and the EU Commission. This loss of credibility should the peg eventually collapse in chaos is one of the considerations that lead some of us to argue strongly from the start against going down this road. But few would listen.

Beyond the immediate issues of the peg, there are also serious structural considerations which make this kind of "body-with-two-heads" approach less than desireable in delicate situations such as this. Even if all we have here is - as some would suggest - a soft-cop hard-cop duet, the policy of letting the EU Commission permanently play the role of soft cop is hardly desireable, especially for the message it will be sending to Southern Europe, where our improvised duo may soon find themselves once more forced into action. And especially also for financial markets where nervousness about the ability of Europe's complex institutional structure to handle the evident continuing weaknesses in the banking system is still highly evident. Leaving the impression that the EU itself is not able single handedly to deal with its own recalcitrant offspring is not exactly the best way to convince the sceptics.

Today's Latvia Roundup

The exact state of play in the negotiations with the IMF is still far from clear. Latvia's Prime Minister Valdis Dombrovskis said on Thursday that talks with the IMF were making progress on issues of pensions and taxes and results of the talks are expected early next week, but since we have been getting news like this for some days now it is hard to draw conclusions.

Izabella Kaminska at FT Alphaville thinks the analyst community is increasingly interpreting the deadlock as yet another (and possibly decisive) chink in the armour of Latvia’s euro-peg defence, citing in particular the latest research note from the RBC Capital Markets’ emerging markets team. While Capital Economics' Neil Shearing is even more explicit:

Relations between the IMF and Latvia are deteriorating quickly, raising the prospect that the loan programme that is vital to maintaining the country’s currency peg could collapse altogether..... with relations between both sides souring, and the pain in the real economy intensifying, it remains to be seen how long a new agreement will hold. Indeed, there is a growing risk that the programme could collapse altogether, which would spell the end of the currency peg and trigger a round of debt restructuring.

As for me, I agree with Neil, this situation has now become so unstable, while the internal devaluation is working so slowly, that the Fund really need to think about how to handle the damage containment issue. The crisis is far from over in the East and South of Europe, and the risk of a spark from this whole fiasco setting either Athens or Madrid alight is most certainly non-negligable. I advise all concerned to think very carefully at this point about the implications of what they are doing, for the sake of all our well-being. The Maginot line may still be far from broken, but a distant fortress on our outer defence ring may well be about to fall. Let's just learn the lessons shall we?

Why Latvia Is In Such A Mess

2009-07-22T14:22:00.000+02:00

Hat Tip to Aleks Tapinsh - "No wonder this country is in such a mess. Someone posted this video of a payday at the Elkor electronics chain in Latvia. The paycheck as you can see comes in an envelope, in cash. No one pays any taxes. And everyone happy. Or not".

Second example: Prime Minister Valdis Dombrovskis cited in a press conference in Riga yesterday the fact that some companies, including state-owned companies like Latvian Railways, had tried to cheat the social security system by significantly raising the wages of some of its employees (in his example from 1,000 lats a month to 12,000 lats a month), thus apparently raising their pay into the social security system. That way, if a person gets laid off, they'd get 70 percent of the new and improved wage.

Now two recent quotes from my blog interpreting yesterday's comment from the Economy Minister - (Viz: "Representatives sitting in Washington and educated at Yale do not fully understand what is going on in Latvia”)

"To provide with logic behind quote of the economics minister, I believe he thought that the EC and IMF does not realize the scope and importance of grey economy in the country. With that figure hard to estimate (ranging from 15%-40%). Any increase of Tax base will only push the economy on the gray side both for individuals (tax exemption on income earned) and for companies (unaccounted cash revenue, forgone taxes,etc). Thus resulting in even less tax revenue that initially had and larger budget deficit to balance. As for VAT tax, as a sign of protest, some of the local companies have publically annouced the full closure of their business if the VAT is raised to 23%."

"Yep, stupid comment when at the same time you are reaching out your hands to receive their money... That said, the IMF does not really fully understand if they think they can introduce e.g. a progressive income tax and raise more revenue. Very hard to do in a country that does not believe that higher taxes will benefit the population and where tax avoidance is an art mastered by most."

As one wise woman said yesterday "Not everything in Latvia is what it appears to be".

Danskebank's EMEA Daily Latvian Quote Of The Day

2009-07-21T15:19:00.001+02:00

Quote of the day: "Representatives sitting in Washington and educated at Yale do not fully understand what is going on in Latvia", Latvian Economics Minister Kampars yesterday on the Latvian TV programme 900 sekundes.

As they point out, when the borrowers publicly criticise the lenders in this way, something must be going on.

While Mr. Kampars might be right on his assessment of the IMF staff, it is certainly unhelpful for further negotiations (if there are to be any) to bad mouth the institution that is supposed to give Latvia a loan. In our view it increasingly looks like the IMF will not pay out the next instalment on Latvia’s loan. This not only has ramifications for Latvia, but should also be a reminder to investors that the IMF is not just a “money machine” that automatically bails out all countries with funding needs.

Also Danskebank provide some simple calculations to illustrate the extent to which Latvia does still need the IMF funds:

A back of the envelope calculation illustrates this. In June, central government spent about EUR 125m more than came in revenues and funding. Assuming that this “burn rate” continues for the rest of the year (August-December) then that adds up to EUR 625m for the rest of the year. Furthermore, during the rest of the year EUR 715m worth of t-bills are maturing which need to be rolled over. Hence, the refinancing of maturing debt and the monthly cash burn adds up to EUR 1,340m. In our assessment the Latvian state treasury probably has EUR 540m in liquidity at the moment. That leaves the Latvian central government with a funding need of EUR 799m. This is why it is important that the EC in the Supplemental MoU ties up half of the EUR 1.2bn instalment for the financial sector, as the amount that will be “free” to cover the budget deficit will be less than the funding need (EUR 600m vs EUR 799m).

Thus, according to Danske the Latvian government will be around 200 million euros short by the end of the year – unless it is able to roll over more than half of the maturing debt, something which would require sustained perfect conditions for issuance in the local money markets for the rest of the year, unlikely given that the international markets are more or less closed to Latvian debt, and that non receipt of the IMF share would hardly increase the risk appetite.

Parex Update

The situation at Parex bank seems to be giving rise to all sorts of speculation at the moment. It has been suggested that the Banks owners have been systematically taking advantage of the bailout to line their own pockets. Some support for this view can be found in the statement of the Latvian Finance Ministry last Friday that it had asked the state prosecutor's office to probe Parex takeover last year.

RIGA, July 17 (Reuters) - Latvia's Finance Ministry said on Friday it had asked the state prosecutor's office to probe the state takeover last year of a major bank that helped trigger the need for the country's IMF-led bailout.

The IMF has delayed its latest share of lending in the bailout, though the EU has decided to give a further 1.2 billion euros. The prime minister said he would hold more talks next week with the International Monetary Fund (IMF). Some local media reports and politicians have criticised the wisdom of taking over the country's second largest bank, Parex, and the way it was done. Most recently the media has reported that some former employees left with big handouts. Finance Minister Einars Repse said he had asked the prosecutor's office to investigate the takeover to clear up such controversies

What the connection is (if any) between the "Parex affair" and all the other unknowns we have in our equation set at the moment still remains to be seen.

And finally, to close, here's yet another Latvia quote, this time from former IMF chief economist Ken Rogoff:

“It is so clear that Latvia’s peg is ultimately unsustainable, all protestations by Latvian government officials notwithstanding,” said Kenneth Rogoff, a former chief economist at the I.M.F.. “But ultimately unsustainable pegs can go on for years before crashing and burning, and Brussels seems to be willing to pay a lot to get past the financial crisis before cutting the cord on Latvia.”

Brief Latvia EU Loan Update

2009-07-20T20:35:00.000+02:00

Well, there is still effectively no word from the IMF. But The EC did today release an addendum to its memorandum of understanding with Latvia identifying a number of economic and fiscal policy measures it wants the country to enact before it receives next chunk of funding. The document, which is a pretty rough-and-ready PDF photocopy, can be found here. Reading the document, one thing seems certain: the upcoming tranche of 1.2 billion euros will not now be sufficient to cover the budget deficit for 2009, since the EC requires half of the money to be set aside for the financial sector - which prompts the question, is the nationalized Parex bank really as healthy as the government and the bank's leadership have previously said it was?

Other items of interest in the document are the proposal to raise VAT in 2010 from 21% to 23% if other forms of revenue raising cannot be identified. The impact on already very hard pressed retail sales is not too hard to imagine. The introduction of a residential real estate tax is also proposed with local authorities being empowered to increase the real estate tax to 3% of cadastral values. If implemented, this will do only one thing: further reduce Latvian real estate values which are already down 50% from their peak, and on whose bottoming-out any hope of ultimate recovery depends.

Which is another way of saying that in macro economic terms the document leaves rather a lot to be desired, and essentially it is hard to find any item which is actually going to stimulate rather than flatten a recovery.

Also worthy of note is the requirement that Latvia now has to closely coordinate policy with the EU and the IMF.

"All significant Cabinet decisions or other decisions with a fiscal impact, including on social security or any guarantee scheme, shall be announced and undertaken only after discussions with the EC and the IMF,"

The document also stipulates that the government will have to report every month on all key aspects of spending and revenue, including providing a breakdown for each ministry as well as for local governments. These performance criteria, given the now near total dependence of the country on external support - de facto, as a sovereign state Latvia has effectively ceased (at least temporarily) to exist, some 19 years or so after its foundation - are not surprising in and of themselves, but it could have been hope that the country would have been better served in terms of the kind of advice which is being offered. The document repeated that Latvia should aim to reach a budget deficit of 10 percent of gross domestic product (GDP) this year, 8.5 percent in 2010, 6 percent in 2011 and 3 percent in 2012, numbers which, if my back of the envelope calculations are not totally awry mean that Latvia's debt to GDP will be outside the EU 60% limit by the time the deficit comes down under 3%, depending on GDP performance in 2010 and 2011. In any event it will be touch and go. So you enter by one door, only to leave by the other.

IMF Imposes New Conditions On Latvia

2009-07-15T11:36:00.000+02:00

Izabella Kaminska at FT Alphaville has the story (via Reuters):

The International Monetary Fund has put forward new, difficult conditions for Latvia to receive further loans, the prime minister said on Wednesday in a further sign the Fund is being tougher than the European Commission.

It isn't clear at this point what these conditions are. Rumour has it they may be an end to the flat income tax, or a hike in VAT. A hike in VAT would be more hari-kiri, since this would again hit consumption AND would boost inflation at a time when they are trying to deflate to carry through an internal currency correction. It also isn't clear whether this is a serious attempt to add new conditions (which I find unlikely, given how advanced the distemper is) or whether this is a way for the IMF to get themselves off the hook (ie leave the EU Commission to stew in its own juice) without having a public and potentially damaging break with the EU. The IMF need to find some sort of exit strategy I think (since Latvia evidently at this point doesn't have one), or it risks losing its own credibility if it puts a seal of approval (by granting the next tranche) on something which most external specialists now think could end up in a very messy grande finale. Argentina ghosts are stalking the corridors in Washington, not because of the similarities between the two countries (they are, at the end of the day pretty different), but because of the way giving a final "kiss of death" loan to a country can ultimately come back and haunt you.

Update One

The local Latvian news agency is saying that if Latvia and the IMF do not sign the new agreement by Friday, Latvia may not see the next chunk of the IMF loan and it could jeopardize the further funding from the EC. This could be brinksmanship, but even brinkmanship can go badly wrong if the other party can't concede. And who is the other party here? Latvia or the EU Commission, since they already said they are happy with progress. What a muddle!

Update Two - Thursday Afternoon

Bloomberg's Aaron Eglitis reports this afternoon that Friday may in fact not be any kind of deadline. He quotes Caroline Atkinson, head of external relations at the IMF, in Washington, to the effect that the head of the IMF mission in Riga is returning to Washington this weekend as scheduled, while the mission itself would “continue its work.” This suggests there will be no final decision this week. She also said there was “broad consensus among all the parties involved” about the goals for Latvia, declining to go into specifics.

Rumourology has it that the IMF wants the government to become more effective in revenue collection, with the fear that the current contraction may be so strong due to the fact that part of the economy is disappearing back into a "grey area" as a backdrop. Various proposals are being floated around, but perhaps it would be better to wait for some concrete information before speculating about this.

Latvian central bank Governor Ilmars Rimsevics has also been holding a press conference in Riga today, and he took the opportunity to suggest that the country’s budget deficit was likely to grow to between 9.5 percent and 10 percent this year. If this is the case, then this would obviously put Latvia outside the 60% gross debt to GDP criteria by 2010, which would make euro membership as an exit strategy non viable over the relevant horizon in my view. Just a long shot, but maybe that is what they are all arguing about. The EU clearly has to offer the four peggars more in the way of a carrot, although they themselves need to remember - looking over at Slovakia and Slovenia - that mere euro membership is no panacea to cure all ills.

The IMF/EU Commission Rift On Latvia Seems To Be Deepening

2009-07-13T21:02:00.000+02:00

Two weeks ago I drew attention to a revealing press conference given by IMF First Deputy Managing Director John Lipsky and European Central Bank governing council member Christian Noyer where it seemed a rather different posture was being taken on the Latvian question than that which is being transmitted from Brussels. Then P O'Neill found a message on Twitter which suggested the topic of the Latvian budget had been unexpectedly added to the EcoFin agenda.

Today Bloomberg report that Barclays Capital’s chief economist for emerging Europe Christian Keller thinks that the IMF's posture of continuing to withhold funds even after the approval of the spending cuts “signaled that the rift between the IMF and EU has widened” .

Now I don't want to see connections were there are none, but it is a coincidence that Christian Keller works for the same Barclays capital whose Head of Emerging Markets Strategy Eduardo Levy-Yeyati recently published a lengthy analysis on the influential Is Latvia the new Argentina? - where he argued that: "The strategy of engineering an “internal” depreciation under a peg in Latvia (via contractionary fiscal policy, wage cuts and price deflation) implicit in the IMF program is proving too painful, if not self-defeating as in the 2001 collapse of Argentina’s currency board"

Now the publication of this article was interesting since Eduardo Levy-Yayati is not just any old economist. Previous to joining Barclays Capital, as his Voxeu biography informs us, he was

"a Senior Financial Sector Advisor for Latin America & the Caribbean at The World Bank. Previously, a Senior Research Associate at the Inter-American Development Bank, the Director of Monetary and Financial Policies and Chief Economist for the Central Bank of Argentina, and the Director of the Center for Financial Research and Professor of Economics and Finance at Universidad Torcuato Di Tella. He has also worked as consultant for the IMF, the World Bank, the Inter-American Development Bank, the Japan Bank for International Cooperation, among many public and private institutions. His research on emerging markets banking and finance has been published extensively in top international economic journals. "

That is, Señor Levy-Yayati is an extremely experienced economist, an old Argentina hand, and enjoys some considerable influence over emerging markets issues in Washington. So was the appearance of the article in Voxeu at the end of June totally coincidental? He certainly is experienced enough to know what he is doing in these matters. And was it also a coincidence that only a week later former chief economist at the International Monetary Fund Ken Rogoff - surely another person who knows perfectly well what he is doing - gave an interview where he said that "Latvia should devalue the lats to avoid a worsening of its economic crisis" and that "the IMF made the wrong decision when it allowed Latvia to keep its currency peg"?

The IMF cannot say what it really thinks for obvious reasons, but could we construe Levy-Yayati and Rogoff as thinking out loud on the funds behalf?

The clash between the two institutions (should such a clash exist) derives from “ideological differences” according to Keller. "The IMF is focused on economic questions such as the sustainability of the currency peg, the use of economic stimulus or the idea of fast-track euro adoption......The EU’s main concern is political, such as euro-adoption rules and the implementation of convergence programs".

This all rings pretty true, and it rings even truer when you note that the Latvian Prime Minister Valdis Dombrovskis said only last week that the country "may not need the IMF share of the financing". As Keller says, “The Latvia program has become a headache for the IMF.”

Postscript

Latvian foreign trade was down again in May, at 618.3 mln lats it was 4.2% (or 27.1 mln lats) lower than it was in April (no green shoot here) and 38.5% (or 387.6 mln lats) down on May last year, according to provisional data of Latvian Statistics Office. May exports were down 30.1% over May 2008, while imports were down an incredible 43.7%. Over the January – May period foreign trade was down by 35.4% on the same period in 2008. Exports were down by 27.7% and imports by 39.9%.

Industrial output fell back again in May over April, by 0.4% on a seasonally adjusted basis according to the statistics office. Year on year it was down 19.3%.

And domestic demand continues to weaken. Retail sales were down 0.48% in May over April, and 24.14% year on year, according to Eurostat data.

Latvia’s inflation rate fell to 3.4 percent in June, the lowest annual rate since October 2003, from 4.7 percent in May. Prices were down 0.5% on the month, but this is way too slow for the kind of internal devaluation process which is underway. At this rate the loss of GDP will be truly massive before the internal currency correction has taken place.

There were 206,000 people unemployed in Latvia in May, or 16.3 percent of the labour force, according to the latest Eurostat data. This is slightly down on earlier data, but since these results are survey based, and such rapid changes make it difficult to apply such methodologies, I don't think we need suspect any kind of "foul play". The rise is dramatic enough as it is, as can be seen in the chart below. This makes me wonder were we will be by mid 2010.

One area where the central bank has had some success has been in getting overnight interbank lending rates down again, and the overnight Rigibor is now back around 3% (13 July), but the 12 month rates are still very high (20.2% 13 July) which does suggest that while market participants are fairly sure the peg is safe in the short term, they are not at all convinced about what is going to happen in the longer term. And in this they seem to be making a valid judgement, since this is the situation at the time of writing.

Meatime Latvia's natality continues to suffer under the weight of the crisis, there were 1750 live births in May, down 15.3% on May 2008. Thus, not only are we playing with the countries short term future here, we are also putting the possibility of having a long term one at risk.

Where Is The Endgame?

When it comes to the short term dynamics of the looming currency crisis in Emerging Europe, one of the Baltic Three, probably Latvia, will most likely be the first to concede its peg, as Eduardo Levy-Yeyati says this is just too painful, and the loss of GDP which is taking place while the politicians are dithering is fearful.

But when Latvia does leave its peg, then others are almost bound to follow. Everything depends on whether the EU Commission and the IMF are proactive or limit themselves to a mere reactive, problem-containment role. If the Latvian currency realignment is done in an organised and systematic fashion, then it may, even at this late date, be a containable process. For this to happen the EU Commission have to stop playing with the politics of the situation, realise that the Maastricht criteria were not written in tablets of stone, and start to formulate a reasonable exit stratgey for all the Eastern members of the EU. They need, that is, to start thinking practical economics, the way the IMF now seem to be doing. The macro economics of this was always clear and straightforward.

But if the Latvian situation is simply left to fester, and the country falls into the grip of a growing political anarchy, then containment will be much more difficult, since panic will more than likely set in.

A similar situation pertains in Bulgaria (see my latest post on Bulgaria, since the similatities are evident). Absent a Latvian devaluation, it is not unthinkable that the Lev peg may be maintained in Bulgaria for another year or so. But if the Bulgarian authorities do go down this road, then we face the severe risk of a a further raggedy ending, since the problem is not one of sustaining the peg, but of restoring competitiveness and economic growth, and this is much more difficult without a formal devaluation. And if Bulgaria does go hurtling off that cliff on which it is currently perched, then just be damn careful it doesn't drag half of South Eastern Europe careering after it. The EU Commission need to begin to resolve this mess, and the need to begin now!

Estonia's Neck Goes Into A Latvian-style Noose

2009-06-30T13:54:00.001+02:00

Well, today is the 30 of June, and still no news from the IMF on releasing the next tranche of the Latvian loan. Perhaps this is one of the reasons why (via Ott Umelas at Bloomberg).

Estonia’s fiscal deficit under European Union terms more than doubled in the first quarter from a year earlier, indicating the Baltic country may not be able to adopt the euro in January 2011. The deficit, including social security and state and municipal spending, rose to 5.57 billion krooni ($502 million) from 2.06 billion krooni a year earlier, according to data published on the statistics office’s Web site today. The gap corresponds to 2.5 percent of gross domestic product, according to Bloomberg calculations based on the Finance Ministry’s forecast for Estonian GDP for 2009.

The first-quarter figure means the government will have to keep the deficit at 0.5 percent of GDP for the rest of the year to meet euro-entry criteria. Finance Minister Jurgen Ligi has said he sees no improvement in the economy before the third quarter. The minority Cabinet of Prime Minister Andrus Ansip has cut the 2009 budget deficit by 16 billion krooni, or 7.3 percent of GDP, in recent months to avoid depleting state reserves and keep the fiscal deficit at last year’s level of 3 percent of GDP, the same as the EU’s budget-deficit threshold. This would allow Estonia to adopt the euro in January 2011, the government’s main economic goal.

So why a "Latvian-style" noose? Because these countries have built for themselves a sort of "paradox of fiscal thrift" connundrum, whereby the more you cut, the more GDP falls, the more revenue rises, the more spending grows, the more the fiscal deficit goes up, the more you have to cut, and so on. In the end, as Kenneth Rogoff said yesterday, it simply becomes too painful. There seems no way Estonia can achieve a 3 percent deficit this year at this point. And remember what IMF First Deputy Managing Director John Lipsky said last week.

“If there is a solution it begins with macro policies,” Lipsky said. “No single exchange rates solution, or exchange regime represents a solution to these kinds of problems. What is important is that the currency regime is credible and coherent”.

Estonia now has no exit strategy, at least not to join the euro in 2011 it doesn't And then we have Lithuania and Bulgaria to think about. Basically, the ECB and the European Commission should never have drawn a line in the sand across the original Maastricht criteria. But it's too late for that now.

For Background Reading and Arguments on All This, See:

Why The IMF's Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake
Why Latvia Needs To Devalue Soon - A Reply To Christoph Rosenberg
Latvia - Devalue Now or Devalue Later
The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation
Why You Need Devaluation - An Open Letter To The People Of Estonia<
Devaluation, Euro Membership And Loan Defaults - Some Thoughts For My Critics

And For Why It Is The Baltics Have The Problem In The First Place, See

Is The Latvian Economy Running Out Of People?

The Clock Is Ticking Away Under Latvia
Taking Solow Seriously - Does Neoclassical Steady State Growth Really Exist?
Latvian Population Dynamics
Hard or Soft Landing in Latvia?
Latvian Fertility

Are The IMF and The ECB Lining Up Against The EU Commission Over Latvia?

2009-06-29T18:26:00.000+02:00

There was a very interesting and revealing press conference given by IMF First Deputy Managing Director John Lipsky and European Central Bank governing council member Christian Noyer in Paris on Thursday. Christian Noyer said that, in his opinion, Baltic countries like Latvia would not be helped by joining the single currency (the euro) prematurely.

"It's in the interest of candidate countries not to enter too early because it risks making the economic situation unbearable," Noyer said.

Lipsky, for his part stressed the region could not depend on any particular foreign exchange regime to shield it from the effects of the financial market crisis:

"If there is a solution it begins with macro policies," Lipsky said. "No single exchange rates solution, or exchange regime represents a solution to these kinds of problems. What is important is that the currency regime is credible and coherent".

Do I detect a shift in emphasis here? Certainly Latvia's currency regime is not credible (most external observers now consider devaluation inevitable), nor is it - in my opinion - coherent. And there has only been a deafening silence coming out from the IMF in recent days on the topic.

The EU finance ministers have decided to support maintenance of the peg, but that is hardly surprising, however, Swedish Prime Minister Fredrik Reinfeldt told Reuters, again rather revealingly, that "We think that a clear signal of support from the EU would help them to achieve support from the IMF." That is, the IMF is wavering, and the EU is putting pressure. This, approach, however, suffers from the flaw that it is hardly either coherent or convincing.

Now the Latvian parliament approved budget cuts of 500 mn Lati for the 2009 budget on June 16, a vote which lead the EU to decide to release the next 1.2 billion euro tranche of the emergency loan to Latvia. So why is the IMF still assessing the situation? Some draw consolance in the idea that the IMF’s share of the program is smaller - only 1.7 billion euro in comparison to the 3.1 billion which is coming from the European Commission. But this is to neglect the strategic role the IMF is playing in the whole process. If the IMF isn't leading, then what is it doing. Evidently, the fissures which may be developing between the Commission on the IMF approaches only serve to draw more attention to the complexity of the whole current EU economic and political architecture.

Latvia is a sovereign country, also member of the European Union. Looked at from one point of view, what was the IMF doing there in the first place. But once they have taken leading responsibility, it is not wise for the Commission to try to claw this back from them. After all, the whole process is supposedly intended to raise investor confidence, something which is hard to do if there is not unity of purpose.

Meanwhile liquidity conditions continue to remain tight, and Rigibor interest rates shot up again at the end of last week, following the termination of the summer solstice holiday.

The last official news we have said simply that the IMF would decide on the Latvian loan after June 26. Well we are now after June 26, and we are still none the wiser.

Meanwhile Latvian's continue to save, and outstanding private debt fell in May to 14,140.2 million Lats from 14,252,4 million Lats in April. They year on year change is now down to only 1.6%, and will more than likely turn negative in June, which means that, with the government also trying to save hard, continuing contraction is completely guaranteed without exports.

And today we have two additional pieces of relevant news. Firstly, and most interestingly, former IMF chief economist Kenneth Rogoff - now a Harvard University professor - has said the IMF made a mistake, and should never have allowed Latvia to keep the peg. (That is, he agrees with what Krugman and I have been arguing all along). The IMF, however, is still maintaining an apparent vow of silence on the whole situation, or so it seems, and have yet to pronounce. Hello, EU Commission, how can you lose your heads, when all around you are keeping theirs?

Latvia should devalue the lats to avoid a worsening of its economic crisis, said Kenneth Rogoff, a Harvard University professor and former chief economist at the International Monetary Fund, in an interview with Direkt. The IMF made the wrong decision when it allowed Latvia to keep its currency peg, Rogoff said in Visby, Sweden today, according to the Swedish news agency. While a quick devaluation would be best for Latvia, Rogoff doesn’t believe it will happen for a long time because the IMF and Europe will provide the Baltic nation with loans, Direkt reported. In a normal situation, Latvia would already have devalued the lats and defaulted on its debt, Rogoff said, according to the news agency. World leaders have decided no countries should be allowed to fail and Latvia is benefiting from that, he said.

Secondly Central bank governor Ilmars Rimsevics has given an interview to Reuters TV. He will go down with his ship, like every good Captain should, but there will be no lifeboats for the rest of you.

Latvia will stick to its currency peg and not devalue, even if the country fails to win further loans from the European Union and International Monetary Fund, its central bank governor said on Monday. "People who are expressing that (a devaluation is possible) lack some education and knowledge and I am sorry. There is absolutely nothing to do with devaluation in Latvia," he told Reuters at the Bank for International Settlements (BIS) meeting. "If the cuts (in the budget) won't be made, there would not be financing available, but that in no way would influence or affect the currency peg," Rimsevics added.

The European Central Bank also today urged urged Latvia to rethink plans to siphon off half of its central bank's profits to help rebuild the country's battered finances. Latvia's government plans to up the amount of central bank profits it takes, to 50 percent from the current 15 percent.

In a legal opinion published on its Web site on Monday, the ECB warned the move risked hurting Latvian central bank independence and wiping out funds designed to be a financial safety net for country's troubled banks. "The use of central bank financial resources may be counterproductive from the credibility point of view if confidence in the financial stability and independence of the National Central Bank is undermined," the ECB said.

"It is important to shield the rules related to the distribution of profits from third-party interests and to ensure a legal framework that provides a stable and long-term basis for the central bank's functioning."

One of the most crucial questions going forward is will the process of relative price adjustment, while still keeping the peg, be able to balance the economy, or will it turn out to be intolerable, thus leading nevertheless to devaluation in the end. Although wage growth and inflation are slowing, one could ask whether the adjustment is fast enough to enable Latvia to keep the currency pegged. Uncertainty about the answer is likely to keep the devaluation fears as well as the uncertainty in the FX and money markets alive in the future.
Annika Lindblad: Nordea

Well quite, this is one of the things I have been arguing all along, and now those who in theory support the maintenance of the peg begin to "worry" that the rate of price and wage decline may not be fast enough to maintain the peg. Wouldn't it have been better to have thought a little more about this, before embarking on what is evidently such a risky endeavour.

At the end of the day what we could really say here is, that in a bid to defend credibility, all credibility has now been lost, and things will only get worse from here on in. Tragedy has already repeated its self as tragedy, and now its about to become one of the sickest of all sick comedies. I think it's time to put a stop to the agony.

Facebook Links

2009-06-20T11:41:00.001+02:00

Quietly clicking my way through Bloomberg last Sunday afternoon, I came across this:

Facebook Members Register Names at 550 a Second

Facebook Inc., the world’s largest social-networking site, said members registered new user names at a rate of more than 550 a second after the company offered people the chance to claim a personalized Web address.

Facebook started accepted registrations at midnight New York time on a first-come, first-served basis. Within the first seven minutes, 345,000 people had claimed user names, said Larry Yu, a spokesman for Palo Alto, California-based Facebook. Within 15 minutes, 500,000 users had grabbed a name.

Mein Gott, I thought to myself, if 550 people a second are doing something, they can't all be wrong. So I immediately signed up. Actually, this isn't my first experience with social networking since I did try Orkut out some years back, but somehow I didn't quite get the point. Either I was missing something, or Orkut was. Now I think I've finally got it. Perhaps the technology has improved, or perhaps I have. As I said in one of my first postings:

Ok. This is just what I've always wanted really. A quick'n dirty personal blog. Here we go. Boy am I going to enjoy this.

Daniel Dresner once broke bloggers down into two groups, the "thinkers" and the "linkers". I probably would be immodest enough to suggest that most of my material falls into the first category (my postings are lo-o-o-ng, horribly long), but since I don't fit any mould, and Iam hard to typecast, I also have that hidden "linker" part, struggling within and desperate to come out. Which is why Facebook is just great.

In addition, on blogs like this I can probably only manage to post something worthwhile perhaps once or twice a month, and there is news everyday.

So, if you want some of that up to the minute "breaking" stuff, and are willing to submit yourself to a good dose of link spam, why not come on in and subscribe to my new state-of-the-art blog? You can either send me a friend request via FB, or mail me direct (you can find the mail on my Roubini Global page). Let's all go and take a long hard look at the future, you never know, it might just work.

Another Round in Latvia?

2009-06-16T20:47:00.001+02:00

By Claus Vistesen: Copenhagen

I will forgive my readers if they think that my coverage of the recent debacle surrounding the potential for an imminent devaluation in Latvia has been a bit asymmetric. I mean, here I was; throwing fuel on the bonfire when it looked as if the cracks would make the edifice tumble and now as it seems that those cracks have been temporarily mended, I have gone silent. Well, not entirely then, and this post is thus to show that I actually do attempt to provide a balanced coverage.

Consequently, it seems as if the defences will hold in Latvia, but the apparent vote of confidence from the IMF and the EU commission and thus promises that the external loan financing will continue will not come for free. In order to make due on the loans the Latvian government is planning an unprecented range of spending cuts amounting to an astonishing 10% of the entire fiscal budget according to Bloomberg reporter Aaron Eglitis. These massive cuts include, among other things, a 10% pension reductions and a full fat 20% wage reductions for state employees. As prime minister Dombrovskis is quoted; these cuts should be more than enough to please the debtors in the form of the EU and, most notably, the IMF to whose mercy Latvia finds itself. One would surely hope for Dombrovskis that he is right.

And by all means, it does seem as if markets have been calmed so far [click on picture for better viewing].

As we can see overnight rates have fallen to much more comfortable levels the past few days and we have even had the news that the central bank were actually selling Lats in the open market in stead of its hitherto valiant efforts to maintain the peg, by sucking up domestic Lat liquidity pushing overnight rates up to a massive 100-200% according to a number of, I should say, unofficial reports. Medium term financing in the form of the 3 month and 6 month RIGIBOR remain elevated compared to last month, but so far the massive squeeze in short term financing seems to have abated. Overnight rates consequently fell from an officially reported high of 24.60% to 8% on the 15th of June and further down to a soothing 5% here on Tuesday.

Does it end here then? This seems to be the inevitable question we must ask ourselves.

I have my doubts. First of all, it is difficult to see the big difference here. The fundamentals still look anything but solid and the underlying weaknesses remain. As Edward noted recently in a thorough analysis of Latvia's long term economic potential, the crisis has long and deep roots which go beyond the question of default now or default later. More importantly however, Latvia has now effectively begun a great experiment to see whether it pays off to literally dismantle one's society with the aim to fulfill a distinctly narrow economic objective in the form of a fixed exchange rate. To add insult to injury, the peg itself is not the main goal. Eurozone membership is, and apart from the obvious question of whether such a membership would be a desirable outcome for Latvia at all, I have my serious doubt that we will ever get there.

But that is somwhat for the long term. In the short term, the horizon is still littered with uncertainty and I tend to agree with Danske Bank's Lars Christenses as he dryly notes:

“There really hasn’t been any fundamental change,” said Lars Christensen, head of emerging markets at Danske Bank A/S in Copenhagen. “The only thing that has changed is how long they can postpone a devaluation. The issues are still there, and what will happen when they need the next loan installment?”

This sounds about right to me and although it distinctly seems as if Latvian policy makers are determined to do whatever it takes, the costs will be immense and one has to wonder whether the fort will hold forever? I don't think it will.

Lost In The Latvian Translation?

2009-06-13T20:17:00.000+02:00

According to reports in the Baltic Course newspaper, Latvian Finance Minister Einars Repse (of the New Era party) is not against the strikes and rallies that are being organised in response to the proposed state budget cuts, he is, however, opposed to any violent protests and subsequent civil unrest.

Rallies and strikes are a good thing, but disturbances will not solve anything," Repse pointed out after a meeting with Latvian Free Trade Unions Association representatives today. As the finance minister explains, he realizes that "people are really concerned and desperate", however, damaging government buildings will not contribute to improving the situation in any way as repairing the buildings would have to be paid for with state budget money anyway.

I'm sure he can't have quite put it like this - if he did then a Finance Minister actually supporting strikes against his own measures would be a first, I think (what is happening in Latvia is surreal, but not this surreal, surely) - and that the question is a translation one, but still. It does illustrate the difficult position local politicians are being put in when it comes to defending the EU Commission and IMF inspired measures in the face of their own voters - as I already forecast it would be in my post The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation back in January. More to the point is this, which is real enough:

Working pensioners' pensions will be slashed 70%, all other pensioners will see their pensions shrink by 10%. Also maternity and child care benefits will be cut by 10%.

Now, I know the aim is to bring prices down, but how can a country which is effectively dying for lack of children (post coming on this later) be actually cutting child allowances. Frankly I find this even harder to believe than the idea of a Finance Minister supporting strikes against his own policies. It is nevertheless true. Everything, I see, is possibile in Latvia, except, of course, devaluation.

Green Shoots In Germany, Estonia and Hungary?

2009-06-09T19:04:00.001+02:00

Well, I am busying myself this morning scratching around looking for green shoots in Turkey. But even as I was digging for these I couldn't help notice this coming in over the radar from Germany, courtesy of Bloomberg:

German exports fell more than economists forecast in April as the global crisis restrained demand, keeping Europe’s largest economy mired in a recession. Sales abroad, adjusted for working days and seasonal changes, fell 4.8 percent from March, when they rose a revised 0.3 percent, the Federal Statistics Office in Wiesbaden said today. Economists expected a 0.1 percent decline in April, according to the median of 10 estimates in a Bloomberg News survey.

So German exports have not touched bottom yet - they are still falling. Since the German economy is export dependent, then this implies the obvious, the German economy is still contracting. I don't think anyone ever doubted this, but looking at the way some of the material has been presented recently, it wasn't always clear.

Indeed year on year, exports fell by 22.9%, the fastest rate so far, although since these annual stats are not working day corrected I wouldn't read too much into that just yet, since you really do need to average across March and April due to the Easter impact.

Another country where rather unsurprisingly we aren't seeing too many green shoots at the moment is Estonia, and only today the statistics office reported that exports decreased by 38% and imports by 41% (year on year) in April.

As a result the Estonian trade deficit rose for the second month running, and hit 1.8 billion kroons. So what we are seeing here is a distinct move in the wrong direction, on both counts.

We also learnt from the Estonian stats office today that GDP contracted by 15.1% (year on year) in the first three months of this year - a figure which was revised down from the earlier flash estimate of 15.6%.

Compared to the 4th quarter of last year, seasonally and working-day adjusted GDP decreased by 6.1% (more on all this in another post).

Finally on the green shoots front for today, we could note that Hungary's industrial production plummeted in April by 25.3% (year on year) according to working day adjusted data released by the stats office. This compares with a year on year contraction of 19.6% in March.

Month on month there was seasonally and working day adjusted drop of 5.1% in April, following 4.5% growth in March. So again, output is still falling, and no bottom has been reached.

This latest Hungarian data is particularly unpalatable following a number of reports which had been left open the possibility that the downturn in the Hungarian economy had ground to a halt, or at least staretd to decelerate. If industrial output shows similar weakness in other East European countries then this does not augur well for future German and eurozone output, since Hungary plays a significant role in the early stages of the European manufacturing production chain.

Latvia - Devalue Now or Devalue Later?

2009-06-07T16:30:00.000+02:00

The Latvian economy is certaily stuck in a hard and not especially pleasent place at the moment, and really one chart tells it all, since as we see above the local interbank overnight interest rates have been storming upwards and through the roof over the last two weeks. As a result of this unfortunate state of affairs the country has attained a higher profile in the international news media than most Latvians would ever have dreamt possible, or even, probably, considered desirable. Ever since Claus Vistesen's last post, my inbox hasn't stopped filling up with reports, analyses, forecasts etc. (apart from Claus, FT Alphaville's Izabella Kaminska has had a steady stream of posts - here, here, here and here - while RGE analyst Mary Stokes is a regular follower of the issues - and see again here for some thoughts on the contagion question).

The first issue that hits you is, can such a small country really be that important? The answer is, yes it can, and for a variety of reasons, although among these one is paramount, the so called "contagion" risk. As Danske Bank put it in their latest Emerging Markets Europe analysis:

Increasing concerns regarding a possible devaluation in Latvia yesterday spilled over into other countries in CEE. Although the direct link between the Baltic markets and others such as Poland, Hungary and Romania is very limited it is only natural that concerns over the situation in Baltic States triggers renewed concerns regarding the position in Central and Eastern Europe where many countries to a greater or lesser extent face problems similar to those in the Baltics. Those most at risk from negative spill-over effects are Latvia’s neighbours Estonia and Lithuania although we would expect contagion to affect countries in the region most like Latvia in terms of macroeconomic imbalancessuch as Romania and Bulgaria.

Personally, I think it possible that the immediate contagion risk may be being a little overdone at the present time. Certainly there will be immediate implications from any eventual Latvian devaluation for Baltic neighbours (and co-peggers) Estonia and Lithuania, and well as for more distant Bulgaria. A Latvian decion to break loose will, effectively, be the end of the road for the pegs, even if the unwinding may not necessarily be immediate. And beyond the Baltics and Bulgaria pressure will inevitably mount on other countries facing longer term economic and financial difficulties like Hungary and Romania (which may leave you asking just who exactly there is left inside the EU but outside the Euro - Poland and the Czech Republic to be precise), but my personal feeling is that while we may see everyone placed under stress we are unlikely to see dramatic short term "negative events". If I were looking for these it would rather be towards Russia I would be looking, and to the future path of oil prices, since if things were to go the wrong way on that front then the shock waves from Russia could easily destabilise all the rest of Central and Eastern Europe at one foul swoop.

But then, my relative lack of alarm on the contagion front stems from my perception of the present crisis in the East as less one of short term liquidity and balance of payments pressures, and more one of a longer term sustainability issues, given the relative poverty of the region when compared with West European neighbours, and the rapid population ageing and decline issues it is facing.

Ideological Lock-in?

Latvia is certainly hemmed in on all fronts at the moment, what with the 18% year on year GDP contraction registered in the first quarter, the projected 9.2% of GDP fiscal deficit for 2009 (if more cuts are not made), the rise of overnight interbank interest rates into the high teens, soaring credit default swap rates - Latvia's five-year credit default swap rose to a high of 721.1 basis points on Thursday - and almost vanishing Lati liquidity inside the country.

But over and beyond the immediate concerns, and contagion risk Latvia is currently a test-bed for a number of issues with implications which extend well beyond the borders of this small Baltic country. In particular three questions stand out.

a) The rather counter intuitive idea - which I call the new orthodoxy in this post - that even during strong recessions a fiscal contraction could turn out to be expansionary, if it signals a long term determination towards fiscal rectitude. The IMF put the idea thus:

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

b) The idea of "internal devaluation" as a viable strategy for carrying out a substantial correction in relative wages and prices for a country with a currency peg and large balance sheet exposure to foreign exchange loans. Now it may well be that currency peggars are likely soon to become an extinct species, given the difficulties they tend to produce when such pegs unwind, but the Baltic countries may still be considered as test cases for others who don't (for whatever reason) have an independent currency and thus a serviceable monetary policy. Countries like Ireland and Spain, for example, who are facing a sharp correction, but being inside the eurozone currency area have no local currency of their own to devalue and are hence now destined to follow a similar path to the one being pioneered in the Baltics.

c) The idea that structural reforms can - in the context of a country with long term low fertility, declining working age populations and rising elderly dependency ratios - free up sufficient growth potential to offset the underlying population dynamic and, as the IMF put it in the above citation, credibly signal the possibility of future public sector solvency.

So Latvia is at the heart of a massive experiment, of the kind which lead me to lament on my about page that "Economists hitherto have tried hard enough and often enough to change the world, the real difficulty however is to understand it." Since the question I cannot help asking myself in the Latvian context is: to what extent do we really understand what we are doing here?

The thing is, all of the above mentioned theories - "internal devaluation", "stimulatory fiscal tightening" and structural reforms to offset declining working age population - sound splendid enough, but are the the theories themselves actually valid? How do we test them? And do the measures adopted on the basis of "believing" in them actually work? And are there sufficient grounds for accepting both the validity of the thoeries and the efficacy of measures based on them to ask for sacrifice on the scale that is currently being demanded from the Latvian people? And do we have any consensually agreed benchmarks which would enable us to decide whether the measures are working? Do we indeed - and by "we" here I mean the EU Commission and the IMF - have any inspectable performance indicators against which to measure progress?

Certainly, for every inch of success that is painfully clawed forward (the positive CA balance, for example), we seem to be constantly thrown back a yard by a host of additional problems (the growing fiscal deficit issue, etc), and not for the first time, we - the economists - find ourselves playing with fire, when we, of course, aren't the ones who risk getting burnt in the process!

Plethora Of Statements.

Both the European Commission and InternationalMonetary Fund (IMF) have been busying themselves over the last week making extensive statements on Latvia's 2009 budget amendment process - which is, after all - what lies at the heart of the issue. What has been notably absent however in all these public declarations, is any indication about when exactly the much needed money will arrive. And this is not a request for information simply at the convenience of Latvian lawmakers, it is the sort of information market participants badly need to receive in order to take the kind of decisions which would bring the situation more back under control for the Latvian authorities, and meantime the ambiguity continues.

European Economic andMonetary Affairs Commissioner Joaquín Almunia said in his prepared statement he believes the new budgetary proposals to be a step in the right direction. But how much of a step are they, since he also stressed that more was still needed to contain the rapid increase in the budget deficit. So again, just how much more is needed, and are Latvia's politicians capable of delivering? Or is the pain simply too much to stand?

"Sadly, the economic recession is proving more severe than expected inLatvia
bringing hardship for many and increasing the deficit to higherlevels than
expected. Latvia needs to reduce the deficit in asustainable way with
significant budgetary and structural measures,although I acknowledge that the
original fiscal targets in thegovernment's economic program are no longer within
reach. I alsounderstand there are limits on how much the deficit can be reduced
toallow some breathing space for the economy and for the people ofLatvia,
especially the sections of population most in need. I takenote that the
authorities want to control government debt and maintaintheir exchange rate peg.
The supplementary budget presented this weekis a first step. The Commission
wants to support government's efforts.I am looking forward to seeing additional
steps adopted during the second reading of the budget, as announced by the
government,"

On the other hand, Caroline Atkinson, the IMF's director of external relations, restricted herself to saying the fund agrees with the comments made by Joaquin Almunia to the effect that the supplementary budget presented by the government this week represents an initial move in the right direction. "The government's budget is a first step, and there is more work to be done," she said. Again, how much more work?

When directly asked the key question as to whether the IMF would support a depegging of the lat from the euro, she simply stated that the fund hasn't changed its stance. "We have commented before that the situation is challenging and that there is a need for action, and I think the authorities have stressed the importance of controlling the government debt and deficits and maintaining the peg," she said. That is to say, the Fund's position is that on this topic the government decides. On the other hand, with Latvia's financial and currency markets coming under increasingly evident stress, and Prime Minister Valdis Dombrovskis saying the country needs the second portion of the loan by early next week, the Fund remains meticulously silent on when exactly the next tranche will be paid, and on what it would take for them to release the money. Of course, negotiating in public is not the most desireable of things, but then having hoardes of market participants speculating on what you might be saying isn't exactly a comfortable situation either.

Marek Belka, head of the European Department at the International Monetary Fund, also limited himself on Friday to saying Latvia may need to make further spending cuts as well as increase taxes if it is to stabilize the economy.

The Latvian central bank, for its part, noting all the emphasis on "the government decides" side, and obviously not wanting to be forgotten, issued, for its part, a statement openly defending the currency peg, and warning of "dire losses" for Latvian citizens should the currency be devalued. The bank effectively ticked off public officials and advised them to be more careful what they say when speaking and the national currency and its stability in future. It also took the unusual step of underlining that the central bank was an independent institution, and is the only body empowered to take decisions about changing the currency rate. This was notable, as it could be seen as suggesting that someone else thought they had the ability to take such decisions, and it could also be read as a warning to anyone tempted to think they had such powers.

Meantime the recession goes on, and on.........

Industrial Output Stabilises

Latvian industrial output was in fact up in April over March - by 4.8% on a seasonally adjusted basis. Mining and quarrying were up by 1.8%, manufacturing by 5%, and electricity and gas by 4.6%. Some sectors were up sharply, clothing output, for example, rose 14.6%, pharmaceuticals by 11.6%, and chemicals by 9.7%. On the other hand electrical equipment was down on March by 19.5%, while other transport equipment (defined as ships and boats, railway locomotives and rolling stock) was down 13.2%. Such stabilisation was consistent with what we have been seeing in other countries, and at this point does not enable us to draw and longer term conclusions.

As a result of the improvement in April the year on year output drop fell to 16.9% (after adjustment for calendar effects). The fall was thus weaker than the 23.4% year on year drop in
March and a 24.2% one in February.

The core of the problem is exports, since with domestic demand now sunk into a deep hole, and fiscal austerity the "ordre du jour", exports are the only hope for growth. I mean, this is evident from a simple formula:

Changes in GDP = Changes in private domestic demand + changes in government spending + changes in the net trade impact (exports minus imports)

Clearly Latvia's economy is not condemned simply to shrink forever, but it can come to rest at quite a low level, and for it to rebound something needs to drive growth. What I am arguing is, other things being equal, and relative prices being right, that a combination of new investment for greenfield sites directed to axports (which is a plus for private domestic demand) plus the exports themselves could provide the stimulus which starst to turn the motor over. Devaluation is half of the answer here, with the other half coming from having a responsible government, a serious reform programme which encourages confidence in the country and economic and political stability. End all the speculation which surrounds the continuation of the currency peg would be one way to move forward on the second half of the agenda.

The Latvia statistics office have yet to give us detailed data for Q1 GDP, but they initially reported that the 18% annual decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower (all from a year earlier). "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm recently, and who could disagree.

Latvian exports are also well down, falling 23% year on year in March, an improvement on the 29% drop in February, but still substantial. Going by the April industrial output numbers we could expect a further improvement in April too, nonetheless far, far more will be needed to start to turn this situation around.

In fact, Latvia still ran a goods trade deficit of just under 400 million Lati in the first three months of the year, down significantly from the 650 million Lati in the last three months of 2008, but still large, especially since GDP is shrinking fast.

Lavia's current account has however improved spectacularly, and was back in surplus (although only marginally) as of January this year according to central bank data. This transformation is entirely logical and anticipated (even if the speed of the correction was not), since Latvia is now about to become a net saver, with a current account surplus, and with an economy which is driven by exports, which at the end of the day is what the whole devaluation debate is all about.

In fact, the headline current account surplus number is a bit illusory, since it has been produced by a combination of two factors, neither of which are totally desireable in and of themselves. This is why we could say that the surplus is a forced one, and that Latvia is being forced to become a net saver. In the first place there is the improvement in the goods trade deficit, which as I say, is more produced by a the fall in imports (which follows the decline in domestic spending power and living standards) than it is by any improvement in exports (which have of course been falling):

And secondly we have movement in the income balance, from deficit to surplus, and this, ironically, is produced by the fact that the internal collapse in economic activity means that the income return on Latvian investments (equities, profitability of enterprises etc) has dropped much more than the return on investments made by Latvians outside the country (where things may also be bad, but not as bad as they are in Latvia). Thus ironically, Latvian's who have had the foresight to borrow funds from the Latvian branches of Swedish banks to invest in economic activities in Sweden may well be faring rather better than those very banks themselves who lent money to be used in Latvia.

Retail Sales

Apart from the drop in imports, perhaps the best short term indicator of the contraction which is taking place in internal demand is to be found in the retail sales numbers. These were actually up slightly in March compared to March - by 0.3%, on a constant price seasonally adjusted basis. The improvement was largely in the sale of food products, which increased by 2.7% on the month, while sales of non-food product fell by 1.1%.

Compared to April 2008 however sales were down by 29.6% (working day adjusted, constant price data), following a 27.3% fall in March. Since April last year seems to have been the peak month, we can expect the annual drops to reduce, although the actual level of sales may well keep falling (see chart below).

Apart from the credit crunch and the consequent difficulty in borrowing money, the other factor which is producing the slump in retail sales is the dramatic rise in unemployment, which according to Eurostat data has surged from a low of 6.1% in April 2008 to the present 17.4%. And it continues to rise.

The Eurostat numbers are rather different from the Latvian Labour Board ones, since the latter is based on a different methodology (and is thus not part of any "sinister conspiracy" to hide the facts - for a full discussion of the issues involved see my recent post on the same issue in Spain), but if you compare the charts, the undelying trend is evidently similar, a sharp upward climb.

Restoring Competitiveness

The principal conclusion we can draw from all this then is that it would be foolish to expect any recovery in economic activity to come from Latvian domestic demand, and this problem will only be added to by the impact of debt deflation on houseowners who, according to Global Property Guide, have just seen their properties fall at the fastest rate anywhere on the planet - it wasn't that long ago that Latvia and Estonia were leading everyone up - with prices down by 50% year on year in the first quarter, and the drop over the last quarter of 2008 being an incredible 30%.

So we need to look to exports. But this is where we hit a problem, since all the inflation which took place during the boom side of the boom-bust have made Latvian prices and industries totally uncompetitive when it comes to its main trading partners. If we look at the latest Real Effective Exchange Rate Data (curiously enough released by Eurostat last Friday), it should not surprise us to learn that the worst loss in competitiveness occured in 2008.

The above chart compares Finland and Latvia, and gives us an idea of just how much competitiveness the Latvian economy has lost since the index was set in 1999. In fact the graphs are even more interesting, since we can see that there was a period - between 2002 and 2005 - when, despite the fact that living standards were rising, productivity was rising faster, and Latvia actually improved its competitiveness vis-a-vis Finland. It is that earlier dynamic which now need to be recovered.

But as we can see from the sharp upward rise the the Latvian REER post 2006, the structural damage has been substantial, and this large scale of the correction needed makes the "internal devaluation" path - even if it were working, and even if markets were accepting it, which in neither case is true - particularly onerous. Prime Minister Dombrovskis himself estimated only last week that any devaluation would need to be of the order of 30% (and looking at the chart it is hard to disagree), and this is already much larger than the 15% "adjustment" in the trading band the IMF were considering during the original loan negotiations.

Ideally improvements in competitiveness can be achieved in two ways, through productivity enhancements which can be attained via structural reforms, and through changes in the wage and price level. Unfortunately the former needs time to work, and time is now absolutely something Latvia hasn't got, with the recession biting deeper by the day, and the markets hot on the heels of the government. So we need the wage and price correction. Well, people have supposedly been working on this for some six months or so now, so just how far have we got? Let's take a look.

Well, if we look at average gross wages and salaries, they fell 1st quarter of 2009 by 6.2% over the last quarter, but when compared with the first quarter of 2008 they are still up - by 3.5%. Of course, given the rise in unemployment the actual volume of wages and salaries paid is down even more - by 10.9% on the year, and by 17.2% over the last quarter. But this is a dop in living standards produced by the recession, and not a fall in unit labour costs.

In fact, according to data from the Latvian Statistics Office, the level of gross wages and salaries has so far only fallen back to the level of August 2008. This contrasts with a lot of anecdotal evidence I have been receiving in comments which speak of far larger reductions, but there you are, that is what the data says.

But restoring competiveness via internal devaluation is about reducing wages and prices in like measure, it is not simply about reducing wage costs, since slashing wages without reducing prices is only to cut living standards, and this in and of itself serves no evident purpose, and indeed causes untold hardship.So how are things going with prices?

Well, not much better. According to the statistics office, as compared to March, the average consumer price level in April was down by 0.4%. The average prices of goods decreased by 0.3%, but compared to April 2008, consumer prices still increased, and were up by 6.2%. In fact both the general and the core idexes (by core I mean ex energy, food, alchohol and tobacco) were still above the January level, so on the consumer prices front we have yet to take even the first step into attacking the loss of competitiveness reflected in the 2008 REER.

What about producer (or factory gate) prices then? Well, here the situation is a bit better, since as compared to March, April producer prices were down by 0.9%, while as compared to April producer prices fell by 2.6% (the first month of year on year drop). In the case of export prices, the situation was even better, since these were down by 9% year on year in April. In fact in both cases (domestic and export) prices have been falling since last July, which is hardly surprising since energy costs (which were a major component in the recent producer price spike) have fallen sharply. And remember, what interests us here is competitiveness, and energy prices have been falling everywhere. What Latvia needs is to improve its relative prices vis a vis its main reference markets.

Money Supply Problems

One indicator of the degree of stress which the Latvian economy is currently experiencing is the way in which bank lending (which fuelled the earlier boom) is now falling across the board. Year on year the numbers are still in positive territory, but the annual lending growth rate is steadily heading for zero - it decelerated to 4.3% in April (of which lending to non-financial corporations fell to a 9.2% growth rate while lending to households was down to 1.3% year on year). But month on month lending is contracting, and has been so doing since October. Loans to resident financial institutions, non-financial corporations and households contracted by 115.9 million lats or 0.8% in April alone.

Commercial credit and mortgage lending are both falling (by 3.4% and 0.8% respectively) and the negative momentum continues.

Money supply data show a similar tendency, even if in April M3 increased by 67.4 million lats and M2 by 63.6 million lats over March. Nevertheless the annual rate of decline in both measures of money supply continued to accelerate (to 8.2% and 8.1% respectively).

M1 - which consists of currency in circulation + checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits) + traveler's checks (ie assets that can be used to pay for a good or service or to repay debt) - has been falling now since December 2007.

Net foreign assets held by the Bank of Latvia fell by 218.7 million lats in April. According to the central bank the decrease in foreign reserves was a result of Bank of Latvia interventions (selling euro) and a reduction in foreign currency deposit held by the government as it drew down what remained of the last tranche of the international loan. Latvia has now spent about 503 million euros buying lats so far this year to support the currency. The bank had previously spent about 1 billion euros in 11 weeks last year defending the currency prior to the 7.5 billion-euro IMF-lead bailout.

Reserves had to some extent been boosted by currency swaps made available by the Swedish and Danish central banks. Indeed only in May Sweden’s central bank raised the amount of euros available for its Latvian counterpart to swap for lats to 500 million euros and extended the term of the agreement. The swap agreement dates back to last December, and allowed the Latvian central bank to borrow up to 500 million euros for lats. Under the original agreement the Riksbank was to provide 375 million euros and the Danish cb 125 million euros. However, according to the most recent statement from Swedish Finance Minister Anders Borg the Swedish government have now decided: so far and no further (see below).

Deteriorating Liquidity Conditions

As noted at the start of this post, Latvia is now suffering from a major Lat liquidity squeeze. And the shortage of lati on the internal market lifted has steadily been lifting interbank rates. One indication of the shortage was the inability of Latvia’s Treasury during the week to sell bills at a first auction at which 50 million lati (35 million euros) were offered. The Treasury did finally manage to sell a much smaller quantity (2.75 million lats - 4 million euros) . The problem is not one of price (yield) but of liquidity - there is simply a shortage of lati in the system overall as those who have the local currency sell and buy euros to protect against possible devaluation.

The lack of liquidity pushed Latvian interbank lending rates to their highest levels on record on Friday as the central bank removed lati from the market in an attempt to stem speculation. The six-month Rigibor rate rose to 16.00 percent. The three-month rate rose to 17.92 percent while the overnight rate rose to 19.6 percent. Obviously with levels like this devaluation becomes inevitable, but as Dombrovskis stresses: “This was a momentary situation and the moment when we have an agreement with the international lenders the market will calm down,” - for the time being at least. The critical question at this point is not whether a new agreement with the EU and the IMF is possible (it surely is), but rather whether it is worth the effort, since the government may well be in a situation were it is forced to agree to a series of extremely painful cuts only to find itself in the very same position three or six months from now.

Deficit Connundrum

As we can see, the Latvian people are being asked to make a bet in support of an economic idea, the idea (as presented above) that a fiscal contraction under present circumstances could turn out to be expansionary. Personally I am absolutely not convinced of the validity of this argument. What will convince lenders and investors to return to Latvia is:

a) a convincing commitment to structural reform and fiscal rigour in the longer term
b) a serious adjustment in relative wages and prices which converts Latvia once more into an attractive destination for export oriented investments.

At the present time we have the worst of both worlds here, since all the government's time, energy and attention is being focused on short term fiscal objectives, while the rate of price adjustment is far too slow. That is, the existing programme is NOT working, and I find myself wondering, do the IMF representatives have performance criteria, and if so what are they? And are these (assuming they exist) being in any way fulfilled, since the only visible positive outcome at this point is the recovery of a current account surplus, but if this is being achieved at the price of generating a massive fiscal deficit, then it is hard, really, to cry victory.

The general government consolidated budget showed a deficit of 190.8 million lats in April, with an accumulated deficit since the start of the year of 332.8 million lats). According to the central bank, the deterioration in the general government consolidated budget was largely the result is two processes: a) a revenue fall of 24.7%; and b) an increase in expenditure of 15.9%. Tax revenues were sharply down in all tax groups, with corporate income tax, VAT and personal income tax revenues dropping most (by 84.9%, 26.9% and 15.5% respectively).

The expenditure surge was primarily fuelled by payments of subsidies and grants which expanded by 70.3%. Rising expenditure for social benefits (by 26.2%) and the growth in interest expense (84.7%) were other significant contributors. General government gross debt increased by 143.2 million lats in April (to 3 119.0 million lats).

The consensus is that the current budget as agreed in a first reading before Latvia’s parliament last week implies a deficit of 9.2% of gross domestic product. It is anticipated that spending will be cut further via ammendments in the second reading scheduled for June 17 and that these should be sufficient to obtain additional disbursements from the European Commission and the International Monetary Fund. The question is not really (at this point) whether the Latvian parliament will pass the ammendments, but whether Latvia can hang out that long in the absence of stronger verbal and substantive support, and whether the measures if implemented will have the anticipated results.

On the latter point, as I have already indicated, I am extremely sceptical, and on the former, as we have seen statements from both the EU and the IMF have been much softer than might have been hoped for, while one leading ally (the Swedish banks and government) have now taken a much more ambiguous stance.

Swedish Finance Minister Anders Borg described the situation in Latvia as “markedly worrisome” in a statement on the Swedish government website at the end of last week. However, when it came to practical measures Borg was a lot less forthcoming, limiting himself to stating that Sweden would not offer Latvia any additional bilateral loan over and above the current contribution to the international bailout, adding the in his opinion the most important step forward was a show of determination by the government to rein in the budget gap. “They have to show that they have control over their public finances”. It is of the “utmost importance” that Latvia take “concrete and well-defined” additional measures to limit its public deficit to ensure that the IMF and the European Commission resume loan payment, he told reporters last week.

Swedbank, the largest bank in the Baltic states, has also stressed that they are fully prepared for a possible currency devaluation in Latvia. “We feel comfortable about our action preparedness regardless of which way the Latvian government chooses to go,” Chief Executive Officer Michael Wolf wrote in a statement published on the bank’s Website last week. As he also indicates, he gets the main point about the debt default problem:

“It’s not given that an external devaluation, over a longer period of time, will lead to larger credit losses for the banks,” Swedbank said. “But an external devaluation would give bigger credit losses during a shorter period of time as it directly hits the payment capacity for the many customers who have loans in euros.”

So What Happens Next?

Well , this is very hard to say, but certainly the omens - and especially Friday's Rigibor overnight reading - do not look good.

There is now evidently a growing consensus among observers that some sort of devaluation is well nigh inevitable, with the only real question being when. Certainly the trading community seem to be anticipating such a move, and forward contracts now price the lat some 53 percent below its current spot rate of 0.7073. Bloomberg quote fund manager Paul McNamara , from Augustus Asset Managers, as stating that “There seems to be a reasonable market consensus that Latvia will devalue", and I think this is a fair view.

Caroline Atkinson, director of external relations for the IMF, limited herself to describing the economic situation as “challenging", adding that there was clearly "a need for action.” She also pointed out the need for flexibility, which could refer to the IMF and the budget limit, or could refer to felixility on the part of the government, given the fact "the authorities have stressed the importance of controlling the government debt and deficits in maintaining the peg."

The problem is not that the IMF and the ECB would cease to support the Latvian government if they choose to continue down their chosen path, the question is really will they be able to continue down their chosen path, and indeed does it any longer make sense for them to do so?

No Exit Strategy

During this whole process one thing has become abundantly clear from the IMF statements, for the Latvian government's chosen path to be viable, there needs to be an exit strategy. Really it is very well worthwhile everyone reading the recent interview with IMF Survey Magazine (end of May) given by the IMF’s new mission chief for Latvia, Mark Griffiths, and Christoph Rosenberg, advisor in the IMF’s European Department and coordinator of the IMF’s work in the three Baltic Republics, since it makes a number of things very clear.

Particularly of note are Rosenberg's insistence (which has been a constant on his part throughout the process) that ownership of the adjustment program rests with the Latvian government:

"Let me first stress that this is the authorities’ program—they have very strong ownership of the policies that underpin it."

and secondly, having a viable exit strategy is central to success.

"The alternative strategy—abandoning the peg—would also be associated with large economic short-term costs. That is clearly one reason why there is such a strong preference in Latvia for maintaining the peg. Latvia also has a clear exit strategy in place: meeting the Maastricht criteria and adopting the euro by 2012."

But really, we now need to ask, is this exit strategy still viable? Certainly on the current path it may be possible (on the back of very considerable sacrifices on the part of the Latvian people) to bring the deficit down below the 3% limit in 2011 (although whether the EU Commission and the ECB would regard this as a sustainable process is another issue), but what about the 60% gross debt to GDP ratio? In their April forecast the EU commission pencilled in debt to GDP at 50.1% in 2010 (up from 9.0 in 2007 and 19.5 in 2008). That is debt to GDP is rising very fast (indeed some might say exploding). At the same time this 2010 estimate, which already makes being within the 60% limit in 2011 a reasonably close call (too close for my comfort anyway) is based on GDP contractions in 2009 and 2010 of 13.1% and 3.2% respectively, and we already know that the contraction in 2009 will be significantly greater than the EU forecast.

But it is worse than this, since not only is GDP contracting, prices are also falling (in fact, under the "internal devaluation" scenario this is what we want). But what this means is that nominal (or current price) GDP will fall faster than real GDP, with consequent negative consequences for the debt to GDP ratio (since as GDP falls, the money value of the debt remains constant). In fact the more successful the price correction the higher short term debt to GDP will rise. At the present time the EU forecast GDP deflators of only minus 2.2% in 2009 and minus 3.6% in 2010. But as we have seen above, for growth to return to the Latvian economy prices need to correct by far more than this, and hence debt to GDP will inevitably rise more than forecast - either because prices don't correct fast enough, and hence GDP contracts more (worst case) or that they correct rapidly (but with negative consequences for debt to GDP. This looks suspiciously like a Maastricht lose-lose to me.

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "overdetermined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

Update on the Potential for Devaluation in Latvia

2009-06-02T15:30:00.000+02:00

As I pointed out recently in the context of Latvia and the impending potential for a devaluation there is a distinct risk of falling victim to the sin of crying wolf. Yet, as the plot inevitable thickens I am maintaining, as it were, my cry. There are two significant points to think about in the context of what we might call recent developments. First of all there is the news that the 2009 deficit envisaged in the budget before the Latvian parliament will amount to 9.2% of GDP - significantly higher than the original IMF agreed "limit" of 5%, and even well above the latest negotiating objective of the Dombrovskis government of 7%. Of course, this is just number salad but at the end of the day it is important because it determines whether and under what condition the IMF funded bailout packaged continues. The fact that Latvia reports a deficit of this magnitude almost amounts to throwing in towel in my opinion or at least it means that the playing field is now a different one when it comes to IMF funding. Finally, and in case you think that Latvia has not already cut spending just look at the following estimates for cuts in the public sector:

Taking into account that the budget amendments envisage steep spending cuts, the amendments must be passed immediately, so that the ministries and other government agencies know how much money they will be allotted from the budget this year, stressed the Finance Ministry.

It is planned that the Defense Ministry's budget will be reduced LVL 30.8 million, the budget of the Finance Ministry will be cut LVL 14 million, Interior Ministry - LVL 10.4 million, Education and Science Ministry - LVL 22.1 million, Agriculture Ministry - LVL 20.5 million, Transport Ministry - LVL 109.5 million, Welfare Ministry - LVL 7.2 million, Justice Ministry - LVL 7.4 million, Culture Ministry - LVL 15.9 million, Health Ministry - LVL 39.3 million, and Regional Development and Local Governments Ministry - LVL 10.8 million.

The initial demands would of course represent even deeper cuts and this is the main point in this case; just how much pain can you inflict under a fixed exchange rate before the dam breaks? As it appears, everyone has a breaking point and with e.g. property prices slumping 50% y-o-y in Q1 alone it is not difficult to see the boom-bust nature of Latvia's recent economic performance.

Another and very important part of the picture comes from the fact that it is not only the IMF who is footing the bill in Latvia. Consequently and this is the case for all three Baltic economies the expansion has effectively been characterised by the outsourcing of the financial sector to particularly Nordic banks' subsidiaries and most notably Swedish owned banks. This creates a large dilemma in the context of devaluation since most of the of the credit to corporates and households have been provided in Euros as result of the so-called road map towards Euro entry which was perceived as a fait accomplit. Recently, RGE analyst Mary Stokes explicitly tackles this question in the context of the entire CEE edifice. Mary frames the issue neatly when she says:

The general idea is that these parent banks (as well as the CEE economies in which they operate) are likely to be collectively better off if they all continue to support their Eastern European subsidiaries. The problem, however, is they may not be individually incentivized to do so.

Mary is initially positive in the sense that we won't see a large scale withdrawal of foreign banks from Eastern Europe citing recent evidence in the context of Romania, Hungary and Serbia where foreign banks have pledged to support their subsidiaries despite strong economic head-winds. However, she also makes a very important point when she coins the notion of the asymmetric prisoner's dilemma. What lies behind this term is the idea that because different foreign banks are exposed to a different degree in different parts of Eastern Europe with different economic fundamentals the idea of a common commitment across the board may be difficult. One key ingredient here is of course, as Mary notes via Fitch ratings, that the extent to which banks are exposed relative to their parent companies differ substantially. This is simply to say that while some banks are indeed able to shoulder the inevitable losses which will come in a CEE context, some are threatened on their life [1]. Finally, there is the risk that if one bank decide to give up its support for the subsidiary and thus the domestic economic edifice in its current form, so will other banks do the same. On a macroeconomic level this would of course be tantamount to one economy deciding to devalue which would immediately, one would assume, force others to follow suit.

As you can probably tell by now I am getting closer to the topic at hand. Consequently, I believe that what is now materialising with Latvia as the main venue is exactly this asymmetric prisoner's dilemma that Mary is talking about.

Let us begin first with the simple and ominous sign that lending conditions in the Latvian interbank market have become increasingly tight recently. I already pointed to this in my previous post (see link above) where I noted how the Latvian central bank, through its currency board, has already spent over 500 million euros buying lats. Last week in particular was tough as Bloomberg reports how the central bank had to buy 95.4 million lati ($190.6 million) in order to protect the Lati from moving below its trading limit where it is only allowed to move 1% either way against the Euro (from a mid point). According to Bloomberg, such purchases have already caused the foreign exchange reserve to shrink by 38% between September 08 and april 09 alone.

Latvia’s overnight lending rate rose to a record today because of a shortage of lati on the market after central bank purchases of the currency and Treasury bill sales, said Andris Larins, an analyst at Nordea AB. Asking rates on the overnight Rigibor, the interbank lending market, rose to 14.2 percent after the central bank bought 95.4 million lati ($191.5 million) to support the currency last week. Treasury bill sales and higher interest rates on money the central bank charges to borrow also contributed, Larins said.

As can be seen the effect from these operations are very as they have driven the interbank rate to its highest in more than 10 years as the central bank purchases are sucking up liquidity from the market. The main message here is that the shorter term rates are converging to the annual rate (click image for better viewing).

Especially, it is important to pay attention to the fact that the overnight rate has skyrocketed and even surpassed the annual rate. The overnight rate has risen 1352 basis points since the 21st of May and it indicates verly clearly how much stress and uncertainty which is building up in the market. Essentially this is the effect Bear Stearns/Lehmann had on the Libor back in the days where global interbank markets were freezing over. Moreover, I have from reliable sources that some banks are quoting overnight rates as high as 20% which suggests that things are moving fast at the moment.

But why all this fuss now then?

Well, it is worth remembering that it already began last week and as I pointed out above the larger than expected announced budget deficit cast serious doubt over the potential for future IMF funding. However, a more prominent reason is certainly that the Swedish banks and Swedish discourse in general have begun to turn strongly towards devaluation in Latvia as a sure thing. Last week, the Riksbank strengthened its foreign currency reserve with 100 million SEK, but more importantly SEB Chief Executive Annika Falkengren noted how the level of defaults would essentially be the same regardless of whether Latvia devalued or corrected through internal price deflation. This kind of message from a Swedish bank executive is not without importance since it is, for a large part, Sweden that have financed the Baltic expansion through the heavy exposure of many Swedish banks in the Baltic economies. Up until now however, popular belief has held that since most of the loans having been offered by foreign banks were in Euros these banks would strongly reject devaluation as it would effective eat up a large part of their balance sheet in one sweep. However, as many of us have pointed out these defaults would come anyway as a result of the sharp and essentially brutal deflationary correction. It is exactly this recognition which seems to have trickled down to Swedish bank officials.

As a consequence of this and, arguably, a host of other things Bengt Dennis, a former Swedish central bank governor and an adviser to the Latvian government was quoted this weekend of saying that a Latvian devaluation is a done deal. The only question would be when and how.

Bengt Dennis, the former Swedish central bank governor and an adviser to the Latvian government on how to cope with the economic crisis, said the Baltic country will need to devalue its currency. “No one knows if there will be a devaluation tomorrow or in a few months -- the timeframe is always uncertain -- but we have moved beyond the question of whether there will be a devaluation and should instead focus on how it will be carried out,” Dennis told Swedish state television SVT last night.

This is of course pretty uequivocal and indicates quite strongly how the end game is near. In essence, it is very obvious I think that the sentiment in Sweden has turned from one in which the desire to wait out the storm and take the losses gradually to one where there is a demand for closure and immediate quantification of the losses. This is significant since the longer markets believe that Swedish banks no longer explicity support the peg, the closer we move towards a devaluation.

Clear signs of such sentiment comes from the publication of the Riksbank's Financial Stability Report out today where it is estimated how Swedish banks will lose as much as SEK 170 billion during 2009 and 2010 on loan losses. Now, it is impossible to say whether these estimates implicitly include a Latvian devaluation or not, but one thing is certain; the estimates have the Baltics written all over them and, if anything, the downside looms as a direct function of the potentially worsening situation in the Baltics. Add to this that the Swedish economy in general have endured an absolutely horrendous 6 months across Q4-08 and Q1-09 and it is not difficult to see from where the impetus to pull the plug in the Baltics could come from. Recent figures for GDP indicate how national output fell 6.5% over the year in Q1-09 which compares to an annual drop of 4.9% in Q4-08.

To add to the pressure it also appears that the political tensions in Latvia is growing.

In the first instance there is of course the expected and almost obligatory refutation of the Dennis' comments about the almost certainty of a devaluation.

I hereby announce that an opinion by Bengt Dennis, member of the High Level Advisors Working Group to the Government of Latvia, which he expressed today to the Bloomberg news agency about an inevitable devaluation of the Latvian national currency – lats – is not true, and should be evaluated as expert’s personal, individual opinion which has nothing to do with issues concerned in the first sitting of the High Level Working Group, as well as with the position of the Government of Latvia on overcoming the economic crisis.

This is of course all well and good, but the question is whether we can take this for granted as the "official" position. For starters, Bloomberg (linked above) quotes Justice minister Mareks Seglins for calling a debate about the potential gains and losses relative to a currency devaluation. This would indeed be something new in a Latvian context as a debate about the Lati's Euro peg hitherto has been stifled completely by the official backing of the Lati's value against the Euro. As people closer to the Baltic situation than me have pointed out, this may a specific attempt to stir up things by Seglins since his party are bound to lose local elections come Saturday and may thus lose the majority in parliament.

A Done Deal Then?

Not quite, but it is impossible not to notice that some significant cracks have emerged. I think it is particularly important that Swedish stakeholders in the Baltic debacle now seem to favor "throwing in the towel" through a devaluation as it is assumed that it would amount to same thing, in the end, as trying to keep things together. Of course, no one other than Latvia herself can choose to devalue but the signs from Sweden are very important in the sense that the Swedish banks are paramount in keeping the economic edifice together. Moreover, there is the IMF where we do not yet know whether bailout funding will continue with the new estimate of 2009 budget deficit. My guess is that the IMF won't stand for it but then again, it would be wise to cut some slack if they have an interest in keeping the peg (which I am not it really wants).

I will end as I did last time with a general warning. At this point rumours will drive the discourse as much as real economic fundamentals and political decions. However, it is difficult to deny that a devaluation in Latvia seems to be moving closer.

---

[1] - Incidentally and for all the complaints about me focusing too much on the similarities between the CEE here is an example of differences. This is to say that when it comes to a high degree of event risk there are of course notable assymmetries. What I would like however to point out is that when it comes to the fundamentals and the underlying problems/courses of the crisis the Eastern European countries are, in many cases, strikingly similar.

Devaluation Imminent in the Baltics?

2009-05-28T11:28:00.000+02:00

By Claus Vistesen: Copenhagen

Even when liars tell the truth, they are never believed. The liar will lie once, twice, and then perish when he tells the truth.

One thing which is certain at the moment is that the rumour mill is grinding hard and that it is very difficult to get a clear picture of what is going on. It is too cumbersome for me to go into the entire background here (I assume most of you are familiar with the Baltic and CEE situation), but if you want some background try this or this which will give you the opportunity to browse a myriad of articles. The situation is however pretty simple. Ever since it became clear that the Baltics was going to suffer not only a hard landing, but a veritable collapse on the back of the financial crisis one obvious question always was whether these economies could maintain the Euro peg throughout the correction process. So far the peg have held and the countries, as well as the IMF who have been called for aid, have been committed to the peg and thus the future entry in the Eurozone.

But this has come at a price and as international economics 101 tells us, the only way you can correct with a fixed exchange rate and an open external account is through deflation and a very sharp drainage of domestic capacity. And so it has come to pass that particularly in Latvia who has come under the receivership of the IMF the scew has been turned, (and turned and turned) and now the question is how much more can the public and the goverment take. In a recent article in the NYT the situation is well described as the Latvian government scrambles to meet ends on the IMF's pre-condition to continue funding the bailout programme.

One very significant indication that things are near its breaking point came when Central Bank Governor Ilmars Rimsevics launched the idea that, since the liquidity in Lati is being drained in order to keep the peg and because the cuts needed to abide by the IMF rules are immense, public employees might be submitted to receive their pay in "vouchers" in stead of actual Lati. As Edward points out, this is straight out of the vaults of the Argentian crisis' annals. This is one of the things you get with a peg maintained too tightly during a deflationary crisis. It deprives you from liquidity. Now, in some sense this all about the next installment of IMF funds of course and whether Latvia will (can) make the needed budget cuts to please the fund to such an extent that they will continue to slip the bailout checks in the mail.

Essentially, under the peg, the central bank has to buy Lati in the open market to maintain the peg since there is, naturally, a pressure on the peg as everybody want's euros. So, the central bank is forced to drain the economy from liquidity to maintain the peg in an environment where the economy is contracting at about 20% over the year. This is not fun and, as it were, not sustainable given the trajectory of these economies. In this sense devaluation is no cure but a simple prerequisite (and necessity) for the healing process to begin.

Even more significant it appears that the the foreign banks, so important in the Baltic story since they basically provided the liquidity inflows to fund the boom, are beginning to accept the basic point I, and others, have made so often before. This is the point that although a devaluation would entail default on a large batch of Euro denominated loans, this default would come in either case as a result of the utterly horrid contraction. In this sense it was very significant that the SEB Chief Executive Annika Falkengren pointed out;

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

This is important because one prerequisite for the peg to hold was always that the foreign banks explicity backed it since they pretty much finance the majority of the credit needed to hold these economies afloat and particularly so Latvia. Essentially, on the Swedish side of things it appears that they are pretty much treating this as over and done.

According to Dagens Industri' Torbjörn Becker, leader of the Eastern European Institute of the School, a devaluation is likely. "The alternative to a devaluation in Latvia is to wait until the reserve is drained and the economy will disappear into a black hole, " he told the DI. Torbjörn Becker believe that neighbors Estonia and Lithuania follow.

Moreover, the Riksbank just recently bolstered its foreign currency reserve with an amount equal to 100 mill SEK which can be interpreted as a precautionary measure to deal with a potential fallout in the Baltics.

The Executive Board of the Riksbank has decided to restore the level of the foreign currency reserve by borrowing the equivalent of SEK 100 billion. This needs to be done because the Riksbank has lent part of the foreign currency reserve to Swedish banks. We have also increased our commitments to other central banks and international organisations. The Riksbank needs to maintain its readiness to supply the Swedish banks with the liquidity required in foreign currency.

Finally, there is Danske Bank, aka Lars Christensen in the context of the CEE, who warns of a serious event risk in the Baltics in today's daily installment on emerging markets.

The event risk has risen sharply in the Baltic markets and we advise outmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

(...)

With worries over the Baltic situation on the rise there is a significant risk of negative spill-over to other markets in CEE. Therefore we see clear downside risk on the CEE currencies and a risk of a sharp sell-off in the CEE fixed income markets in the coming days. We especially see value in buying USD/HUF, but potentially also USD/PLN on an escalation of the Baltic crisis.

Basically, the way I see it is that there is only so much the currency boards can do and in Latvia's case, after having already spent over 500 million euros buying lats, I think we are moving steadily towards the end game. Of course, there is an obvious risk that I will perish further down the road with this one, but then again, so be it. It is imperative that investors and stakeholders entertain the possibility of a multiscale Baltic devaluation and, obviously, a sharp CEE sell off in the wake.

Danske Bank Warn On The Baltics

2009-05-28T10:49:00.000+02:00

Danske Bank has issued the following advice to investors:

The event risk has risen sharply in the Baltic markets and we advise utmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

No comment.

The krona fell for a third day after the Riksbank announced the loan, and declined more than any of the 16 most-traded currencies against the dollar and the euro. Stefan Ingves, central bank governor, said in the statement that the financial crisis may be “prolonged”. Since the start of the financial crisis, Sweden has spent 100 billion kronor on swap agreements with Iceland, Estonia and Latvia and on dollar injections into Swedend's financial system.

Swedish banks have claims in Latvia, Lithuania and Estonia amounting to about $75 billion, according to ING Groep NV, with SEB, Swedbank and Nordea accounting for 53 percent of Latvia’s lending market. Sweden’s central bank raised the amount of euros available for the Latvian central bank to swap for lats to 500 million euros ($670 million) at the start of May. Latvia’s central bank first entered the swap agreement with both its Swedish and Danish counterparts to borrow as much as 500 million euros for lats last December. The Riksbank was to provide 375 million euros and the Danish central bank the remainder.

Latvia has already spent over 500 million euros buying lats this year to support the currency.

Earlier this week the New York Times Economix Blog said the following:

The jury is still out on whether Latvia can do what it takes to rebalance its budget and qualify for the bailout money it received from the International Monetary Fund and the European Union. Take a look at this analysis of Latvia’s situation from Danske Bank, which has consistently offered hard-headed – that is, pessimistic – views of the Baltic nations of Latvia, Lithuania and Estonia. (The bank was also far ahead in calling the disaster in Iceland.)

The most interesting aspect of the story, from a global perspective, was the notion that a default — even by a small country — could trigger a cascade of bad news at a time when the financial situation appears to be easing.

Let us just all hope that this last mentioned "notion" remains just that, "an interesting notion".

Meanwhile, Swedish media seem to be treating the devaluation as almost a "fait accompli" - those of you who don't speak Swedish can try putting this and this through your Google translator if you are interested.

Payment By "Voucher" In Latvia?

2009-05-26T14:41:00.000+02:00

This sounds like something straight from the Argentine history book. Yesterday someone left this comment on my Latvian Blog:

By the way, latest idea in Latvia is to issue vouchers as a substitute to LVL (thats in case Latvia doesnt get any money from IMF). So if you work in public sector, your salary partly will be paid in vouchers which you can use to buy food. And yes - it would also mean 'stable' LVL, at least on paper. I still don't really understand how it could possibly work in free capitalist economy. But it underlines how strong is the will to keep current LVL rate at any means, even if it means total collapse.

At the time I wasn't sure what to make of this, but then I saw that according to a report in the Latvian newspaper Diena, Central Bank Governor Ilmars Rimsevics visited the town of Liepaja on Friday, and told the astounded journalists assembeled there that: "The level of the expenditure shock we are receiving is so high that we can not cease to maintain this quantity of expenditure. So there is a shortage of funds, and we're forced to look at the different kinds of projects, which can help us provide for the foreseeable future. Taking into account that the money is not budgeted, it can be emitted in vouchers".

Rimsevics also gave an interview to the Russian-language newspaper Telegraf (published this morning) where he says more or less the same thing. Basically, the IMF are threatening to withold the next round of funding if the Latvian government does not move ahead with the agreed wave of budget cuts - which in some areas will be of up to 40%. Latvia received a 7.5 billion-euro bailout from the IMF and the European Commission last December. The agreement required Latvia to limit its budget shortfall to to 5 percent of gross domestic product. Since then, the economic outlook has turned far worse than anticipated and Prime Minister Valdis Dombrovskis's government is seeking approval to run a 7 percent deficit.

At the same time the Latvian central bank keeps having to buy the local currency (the Lat) to support the euro peg - last week the bank bought 6.4 million lati ($12 million), and this was the eighth consecutive week they have had to make such purchases. The longer it takes to reach agreement with the IMF - who are convinced that severe budget cuts will be expansionary in the short term (due to the improved confidence they will produce, see here), the more the bank will need to spend to counter those who are betting they will be forced to devalue.

The bank have now bought about 1.1 billion lati since September 2008, and such interventions have reduced Latvia’s foreign currency reserves by 36.7 percent compared with September last year. The flight to euros is also producing strong liquidity pressure inside the country, and the central bank cut its refinance rate to 4 percent on May 13, the second reduction so far this year, in an attempt to boost borrowing amid a liquidity squeeze and much harsher lending criteria. Basically, in order to keep lati in circulation, interest rates on the Rigibor, the local interbank lending market, have been driven up by 42 percent since 3 February to hit 13.7 percent on May 14 (for six-month loans). And this in an economy which shrank by 18 percent in the first quarter.

As I say at the start, all this - including the vouchers proposal - does now sound incredibly like Argentina, since issuing scrip money is exactly the kind of thing you get pushed into when you try unrealistically to hold a peg. It is the begininning of the end. The same thing, exactly, happened in Argentina, where they ran out of pesos and started to issue Patacónes, Lecops, Créditos, Argentinos and a myriad of other exotic bits and pieces of scrip. I give a bit of background on all this in this post on my Spanish blog, while Bloomberg's Aaron Eglitis has a useful summary of the general Latvian situation here.

SEB Accept Krugman's and My Point.

Currency devaluation in the Baltics would not lead to bigger loan losses for Swedish banks, the losses would simply come more quickly and be harder to deal with, according to SEB Chief Executive Annika Falkengren speaking in a radio interview on Saturday.

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

Now what was it Krugman and I were saying that everyone jumped down our throats for:

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

Ms Falkengren has a very peculiar way of looking at things when it comes to analogies:

However, Falkengren said that devaluation without long term policies to get economies back on track was not a good option. "It's like peeing in your pants. It feels good, but only for a very short time," she said.

But essentially she is right, devaluation is not a solution, only a route to solutions. Long term structural reform is needed either way.

Estonian GDP Shrinks By An Annual 15.6% In The First Three Months Of 2009

2009-05-13T15:18:00.000+02:00

Well, the best thing that can be said about this is that it wasn't as bad as the 18% contraction recorded in Latvia.

Estonia’s economy contracted the most in at least 15 years in the first quarter, making it the second-worst performance in the European Union. Behind the number lay a sharp fall in consumer spending and a plunge in industrial output. GDP was down by an annual 15.6 percent, the sharpest drop since at least the first quarter of 1994, according to the flash estimate from the statistics office. The fall follows a 9.7 percent drop in the last three months of last year.

The 15.6% year on year was significantly above the consensus forecast for a drop of 12.8 % and even above more "realistic" forecasts like the Danskebank 14.6% guesstimate, and will obviously have implications for all sorts of things, but in particular for the government budget deficit forecast.

The latest round of GDP numbers from all three Baltic states - Lithuanian contracted by 12.6% and Latvian by 18% - all indicate extreme weakness in the respective economies.

Today's number obviously lends support to the idea that Estonia's economy might decline by more than 15% in 2009. A lot depends on what the next quarter looks like. If the slowdown accelerates the final annual number might be even worse.

According to the statistics office release, output was broadly down for the majority of economic activities, but the steepest decreases were in manufacturing, construction and the retail trade. Weak external demand added to lack of internal price competitiveness meant exports were a further drag on manufacturing performance. Industrial output fell by more 25% year on year in each of the first three months and retail sales have now been falling for 11 consecutive months. Exports plunged 29 percent in January and 25 percent in February.

The weakness of the GDP number means the budget situation will inevitably have deteriorated further, which means that if the deficit target of 3% of GDP is to be maintained the Estonian government will need to respond with even more painful cuts in spending. In general, the performance does not change the outlook for Estonia to fulfil the Maastricht criteria this year, but it does mean that sticking to the criteria is getting to be a harder task with every passing day.

The Agony Continues - Latvian GDP Falls By 18% (Updated)

2009-05-13T13:27:00.000+02:00

Latvia's economy shrank by nearly a fifth (year on year) in the first quarter, according to the latest flash estimate from the national statistics office. Obviously this is a dreadful state of affairs, and illustrates just how difficult the country's chosen adjustment path is proving to be.

Gross domestic product fell 18% year-on-year, and Statistics Latvia reported that the decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower from a year earlier. "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm, and who could disagree.

GDP fell by an annual 10.3% in the fourth quarter of 2008, while the economy contracted over the whole of 2008 by 4.6% following 10% growth in 2007. This is evidently what is meant by the expression "boom-bust".

The latest GDP numbers from Latvia suggest that the actual situation is in fact worse than the already pretty gloomy expectations. In many ways the “worst case” scenario for the medium term outlook for Latvia has now become a reality. Taking into account further tightening on the fiscal front the downturn could become even more pronounced in the coming quarters.

The weaknesses in the economy seem to be pretty broadly. The decline in both the manufacturing and the service sectors continued in Q1. The export sector has been contracting steadily, due both to slack global demand and uncompetitive domestic prices.

Industrial output was down by 23.4% in March, according to working day adjusted data from the statistics office. Manufacturing fell by 26.6%, electricity and gas supply by 14.1%, while mining and quarrying activity actually increased of 25%. The strongest reductions in industrial output were in textiles - down by 59.2%, in the manufacture of motor vehicles, trailers and semi-trailers – down by 52.9%, and in the manufacture of machinery and equipment - down by 47.2%.

Foreign trade has been dropping, and in March 2009 total trade turnover at current prices was 700.6 mln lats, up 8.3% (or 53.7 mln lats) on February, but down 29.7% (or 296.3 mln lats) on March 2008. Exports reached a low in January, and have climbed slightly since then.

Over the whole quarter trade was down by 32.7% (or 963.9 mln lats) over the first quarter of 2008. Exports fell by 26.0%, while imports were down year on year by a whopping 36.5%.

70.8% of Latvia’s March exports went European Union countries, and another 15.1% went to CIS countries. The principal export partners were Estonia (13.3% of total export), Lithuania (13.0%), Germany (10.2%), Russia (8.7%) and Sweden (7.2%). Since all five of these main trade partners are themselves in strong recessions at this point the outlook for improved exports (even were Latvia competitively priced) is not exactly promising at this point.

The drop in imports does, of course, mean that the trade deficit has been steadily improving (see chart below), which means that despite the drop in exports, net trade has actually been positive for GDP in the first quarter.

Price Inflation Still Far Too Strong

One of the key points in Latvia's "non-devaluation" strategy is to get the wage and price level down quickly. Since the only relief can come from exports as the global recovery starts to take shape it is important that as much of the internal deflation process should have been carried out by that point. However when we come to the reality it is important to note that progress has been slow, and far from satisfactory. The consumer price level was down in April by 0.4% with respect to March, but compared to April 2008, consumer prices had still increased by 6.2%. Obviously much of this inflation is already inbuilt, but in the absence of independent monetary policy it is obviously clear that the Latvian government should be doing more to speed this up, otherwise all this is going to take an eternity, the pain will be unendurable, and much of the structural damage well nigh permanent. The Latvian economy could look worse than the Florida coast after a hurricane has passed.

The only really bright spot is that the tradeable sector does seem to have responded rather more rapidly than the rest (as theory would predict) and export producer prices are now falling rapidly.

Company finances are strained, as internal demand is weak and financing conditions tough. In addition, the position of the Latvian consumers is difficult, as unemployment has shot up and wage growth has slowed. 2009 is likely to be a very difficult one for Latvia, and the government faces the twin challenge of both keeping the budget deficit within a limit accepted by the IMF in order to receive the rest of the emergency loan, and of breaking the back of the economic contraction which is currently spiralling away out of control.

Households are obviously also having a hard time, and incoming data on the rise of non performing loans in Latvia is becoming preoccupying. NPLs (loans that are more than 90 days overdue) as a proportion of the total rose to 7.8% in March (see chart below), and while this level is still not excessive, it is that rate of increase that causes concern.

Retail Sales In Freefall

Retail trade turnover was down in March by an astonishing 27.3%.

Compared to February sales decreased by 2.6% on a seasonally adjusted basis. Compared to the last quarter of 2008 retail sales decreased by 14.1% in Q1, while compared Q1 2008 there was a 24.5% drop.

Unemployment Also Up Sharply

Obviously one of the factors driving the increase in non-performing loans is the rapid rise in unemployment. In fact, as elsewhere the rate of increase eased in April, but still the rate of unemployment rose to 11% and the numbers unemplyed to over 120,000, according to the latest data from the State Employment Agency.

At the present time the government is working towards a deficit of 7% of GDP, above the 5% initially agreed to with the IMF. According to the Prime Minister discussions with the IMF about allowing a larger deficit are ongoing. Maintaining the deficit within the 5% of GDP limit is turning out to be increasingly difficult as the economy has contracted much more sharply than anyone anticipated.

According to Latvian economy Economy Minister Artis Kampars the economy has now reached the bottom and on the point of recovery. Kampars said this in an interview with LNT television. Asked about the gross domestic product decrease of 18% in the first quarter, Kampars said that it was logical and expected, but the GDP will start increasing later on this year.

He also said that regardless of the significant fall in the GDP, the government is not planning to revise the budget amendments, which are based on a 12% GDP drop.

Basically this whole view could not be farther from the truth, since the worst is yet to come, even if this may not be in terms of ever stronger rates of contraction. 18% is we have to hope "unrepeatable", as a year on year figure, and the contraction in the future may well be slower. But this is not what matters. The hardship of the Latvian people will undoubtedly increase, as will what is called the level of "distress" when it comes to paying loans. I see no recovery on the horizon, and even though the rate of contraction will almost certainly decline, positive growth is a long time away, and it would be a brave person who was willing to forcast any sort of growth in any quarter before we hit 2011.

Worst of all, the government, the European Commission and the IMF seem to have no exit strategy here. Like the Vietnam war, this recession may prove to have been a lot easier to get into than it was to get out of. Hanging on in the hope of a euro entry which may never be possible is no strategy. Those who didn't want to devalue got the Latvian people into all this, now perhaps they can explain to them how to get out, since the answer isn't obvious, as budget cut upon budget cut only feeds the contraction, which feeds the unemployment, which feeds the rise in non performing loans which feeds the bailouts which feeds the need for more spending and more cuts in services and staffing, which feeds the contraction and so on.

We need to break the circle, or are we just, like Dicken's Mr Mikawber simply going to hang around and wait for something or other to turn up? And if we are, then I'd be firmly locking and bolting the back door, since all those able bright young and educated people will be sneaking off elsewhere as soon as recovery starts up across Europe, and they won't be coming back, and then we really will be in a pickle, won't we? Or are we hoping they will be like his wife Emma, who let her maxim be "I will never desert Mr. Micawber!"

Non-performing Loans In Latvia

2009-05-12T16:40:00.000+02:00

This is all so tragic, and so foreseeable (viz, my original post here, for example).

Krguman on me:

"Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts."

Krugman on himself:

"In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)"

The Latvian Financial and Capital Markets Commission yesterday with numbers on domestic loans currently in arrears.

By the end of Q1 2009, loans in arrears in Latvia amounted to 20.5% of the aggregate loan portfolio of Latvian banks (up 5.5 percentage points from the end of 2008). The aggregate loan portfolio of the Latvian banks was worth LVL 16.4bn (approx. EUR 23bn) at the end of March 2009. Of the bank loans issued to households in Latvia, 22.1% were in arrears at the end of March 2009. Furthermore no less than 21% of mortgage loans were in arrears by March.

Danskebank on the Commission report:

We are quite concerned about the speed at which the non-performing loans are rising. Considering the gloomy outlook for the rest of 2009 NPLs are probably set to increase even more. We highlight that there is not a 1:1 relationship between NPLs and loan losses, but nevertheless these data cause us to believe that bank loan losses will go much higher than current levels – particularly in Latvia but also in the other countries.

And finally Krugman, who can speak for both of us here:

"This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy."

Amen to that!

Estonia's Trade Down, Unemployment Up As Recession Deepens

2009-04-09T14:27:00.000+02:00

Estonia’s trade deficit narrowed to the lowest level in almost eight years in February as the deepening recession cut hard into consumption. The deficit shrank to 1.1 billion krooni ($93 million), the lowest since May 2001, compared with 1.6 billion krooni in January.

Exports fell an annual 26 percent and imports slumped 33 percent, according to statistics office data.

Having a very sharp fall in imports is, of course, one way to close the trade deficit, but the fall in living standards involved in doing it this way is hardly optimum, or enjoyable.

Unemployment Rises Sharply In March

As consumption falls, and with it demand for products and services, so unemployment rises, and at the end of March 54 979 unemployed were registered as unemployed with the Estonian Labour Market Board, an 18.5 percent increase on the February number and an estimated 8.4% of the economically active population. In the last year unemployment has now increased by 220 percent.

At the end of March 9445 young people in the ages of 16-24 and 14 188 persons of 50 or over were registered with the Labour Market Board. 53.6 percent of those registered were men. Registered unemployment was highest in Võrumaa (13.2%), Ida-Virumaa (12.7%), Valgamaa (11.9 %) and Põlvamaa (10.5 %). The lowest levels of unemployment were in Tartumaa (6.7%), Hiiumaa (7%) and Harjumaa (7.2%).

House Price Fall Continues

Median prices of apartments fell an annual 38 percent in Q1 2008 - to 10,495 krooni ($886) a square meter, according to preliminary data from the Tallinn-based Land Board. This compares with a 20 percent decline in the fourth quarter, and means prices have now almost halved from the peak hit in the second quarter of 2007.

The slump in prices adds to signs that what is now Estonia’s worst recession since independence in 1991 is deepening significantly. Rising unemployment and stagnating wages have made Estonians more reluctant to spend, and with retail sales falling an annual 18 percent in February, (the biggest drop on record dating back to 1994), there is little to cheer about. And indeed Estonian consumer confidence fell to a record low in March, according to research unit Konjunktuuriinstituut.

Property and land sales fell an annual 40 percent to 5,316 transactions, the lowest since the second quarter of 2003, the Land Board data showed. The value of sales more than halved from a year earlier to 4.7 billion krooni.

Tourist Numbers Drop

Tourism was down in February 2009, with only 121,000 tourists making overnight stays, 15% less than in the same month last year, according to Estonia Statistics.

In February 58,000 domestic tourists and 63,000 foreign tourists visited parts of Estonia. 77% of foreign tourists stayed in Tallinn, 7% in Pärnu and 5% of Tartu. The number of foreign tourists in Tallinn was down 14%, in Tartu and Pärnu visits were up by 2% (in both cities). In February compared to the same month of the previous year, the number of foreign tourists from Estonia’s main partner countries in tourism — Finland, Russia, Latvia and Germany — decreased. The number of tourists from Sweden remained more or less constant.

Inflation Falling, But We Aren't In Full Fledged Deflation (Quite) Yet

Estonia’s inflation rate fell in March to the lowest level in almost five years as the Baltic nation’s worsening recession and declining fuel prices cut demand. The rate dropped to 2 percent, the lowest since April 2004, from 3.4 percent in February. Prices fell a monthly 0.5 percent.

So while headline inflation is falling year on year, and will soo be in negative territory, there is still a long way to go. In fact both the general and the core price index have been falling for some moths now.

But remember that the general tendency in the Eurozone is also deflationary, so prices will be falling elsewhere too, which simply means that there is rather a lot of heavy lifting still to be done on the wage and price front in Estonia, in fact over 90% of the "correction" still lies out in front in these terms.

Baltic Countries Downgraded

Fitch Ratings cut the credit ratings for Estonia, Latvia and Lithuania one notch, citing growing risks to Latvia’s international bailout which could spill over into the other two countries. Latvia’s rating was lowered to BB+, one level below investment grade, from BBB-, while Estonia’s rating fell to BBB+ from A- and Lithuania’s to BBB from BBB+, the rating service said in a statement today. All three Baltic countries had a negative outlook, meaning further downgrades are possible. This detail is not unimportant for Estonia, since the ECB has a rule (temporarily suspended at present) that it will not accept assets as collateral which do not have at least an A- rating from one credit rating agency. So any languishing in the BBB+ range will make euro access more difficult.