Latvia: Living in the Land of Extremes

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?

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?

"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

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.