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Regaining Competitiveness While Maintaining a Currency Peg – the Case of Latvia

Geschrieben von hkarner - 25. Juni 2012


Authors: Thomas Grennes & Andris Strazds · June 24th, 2012 · RGE EconoMonitor

What would you say if a sportsman whose records had been rescinded because of proven steroid use returned after a period of disqualification and started competing again? Would you take pride in pointing out that his results are below those attained while being on steroids? Or would you rather find his pre-steroid period to be a more relevant basis for comparison? We assume it’s probably the latter.

Some economists apparently think the records set while being on steroids should still be the benchmark. Take the case of Latvia. The economic development of Latvia has been nothing short of a roller coaster ride and has attracted considerable attention during both the boom in 2007, the bust in 2009 and the recovery in 2011. Balanced analyses, such as a recent one by the IMF’s Olivier Blanchard (“Lessons from Latvia”, iMFdirect, June 11, 2012 http://blog-imfdirect.imf.org/2012/06/11/lessons-from-latvia/ ), are the exception. Several economists, Paul Krugman perhaps being the most visible of them all, have repeatedly argued that “the catastrophe” in 2009 and Latvia still failing to reach the pre-crisis level of output in 2012 can be explained by the fact that the Bank of Latvia during the crisis stubbornly refused to devalue the lat, which since the end of 2004 has been pegged to the euro at a rate of 0.7028 lats per one euro. Krugman interprets the Latvian experience as a policy failure, and others, including Charles Wyplosz (“The Eurozone’s May 2010 Strategy is a Disaster”, Economonitor, June 20, 2012 http://www.economonitor.com/blog/2012/06/the-eurozones-may-2010-strategy-is-a-disaster-time-to-pay-up-and-end-this-crisis ), are skeptical about whether the Latvian policy is exportable to other countries.

2005 – 2009: An economy on steroids and an inevitable bust

To draw conclusions about the economic bust, one first needs to understand the preceding boom. To continue the sports analogy, the economy of Latvia was on steroids during the years 2005 to 2007. The increase in foreign borrowing by Latvians during those years brought more than EUR 13 billion of fresh money into the economy. This inflow was more than a fourth of the nominal GDP, which totaled EUR 50 billion during the same period. Other inflows included foreign direct investment, funds from the European Union, and remittances of Latvian residents working abroad. The huge inflows of money led to skyrocketing imports, double digit consumer price inflation in 2007 and double digit real GDP growth rates in 2005-2007. In 2007 the real GDP of Latvia was 34% higher than in 2004. Total employment increased by more than 100 thousand or 10%, but the boom was not sustainable.

To understand why, it is sufficient just to look at the structure of the above growth. A closer look reveals that wholesale and retail trade (largely of imported goods) accounted for about 9 percentage points of the total, construction 5% and operations with real estate and financial services 3%. Job creation was also mainly limited to the above sectors – 34,000 new jobs were added in wholesale and retail trade, but the most spectacular job growth was experienced by the construction industry which added 39,000 people or 45% in three years’ time. On the contrary, employment in the largely export oriented processing industry in 2007 was at about its level in 2004.

In 2009 the tissue that had been grown while taking the steroids melted away. To Paul Krugman, the 18% decline in 2009 was “the catastrophe” (See “Riga Mortis”, http://krugman.blogs.nytimes.com/2010/02/10/riga-mortis/ ). However, it primarily reflected the inevitable collapse of those parts of the economy of Latvia that were not sustainable going forward after the huge financial inflows dried out. If we dissect the GDP decline of about 20% in 2008 – 2009, we see that 6 percentage points of it are related to wholesale and retail trade and 3% to construction– altogether almost a half of the decline is attributable to sectors that showed annual growth rates far above the average during the period from 2005 to 2007 and where the demand spike was largely driven by net financial inflows. Needless to say, Latvia was also hit hard by the decline in global trade in 2009, but that was the lesser problem compared to the collapse of the domestic “bubblenomics”.

2010 – now: Recovery and improvement in external competitiveness

What has happened since 2010? A gradual recovery has been taking place. The seasonally adjusted quarterly GDP in Q1 2012 was already 12% above the crisis trough reached in Q3 2009. Industries relying on domestic demand such as trade and construction are still much below the pre-crisis output peaks as at the beginning of 2012. However, the industries directed at exports, such as the processing industry and transport and logistics, have shown consistent growth and have already surpassed the earlier pre-crisis peaks in volume terms. The tradable goods sector has become more competitive. More importantly, Latvia is one of a few countries in the EU where industrial output has reached its pre-crisis level. There are only two countries that clearly performed better – Poland and Slovakia as can be seen below:

When looking at the above chart one has to keep in mind that Poland never entered a recession even in 2009 and domestic demand has played a much more important role in its industrial output growth than in Latvia.

Latvian exporters have also lately been gaining market shares in the Scandinavian countries and Poland, as the chart below shows:

The above evidence is clearly at odds with the opinion voiced by several economists that Latvia’s internal devaluation did not work. A frequently mentioned argument is that the wage declines were too small and did not achieve a remarkable improvement in competitiveness. For example, Krugman in “Latvian Competitiveness” (http://krugman.blogs.nytimes.com/2012/06/10/latvian-competitiveness ) presented the following data from Eurostat:

However, the above data ignore the important increase in productivity. Unit labor cost, a more relevant competitiveness measure, shows a remarkable improvement since 2008:

Nominal unit labor cost, Index, 2008=100










Euro area

























Source: Eurostat

A negative side effect of the productivity boost, at least in the short term, was employment recovering more slowly than output. A comparison of today’s employment situation with that of 2007 would not be valid, but there are still about 50,000 jobs less in Latvia than there were in 2004. Social programs have been put in place by the World Bank and the national government to help mitigate the consequences. Thousands of people have left the country in search of employment elsewhere in the EU.

Another important factor behind the relatively favorable performance of exports is that most of Latvia’s main trading partners have had a strong recovery from the crisis as shown in the table below. About two thirds of Latvia’s merchandise exports go to the other Baltic Rim countries.

Real annual GDP growth, per cent




































Sources: Statistical offices of the respective countries

However, had the Latvian exporters been uncompetitive, they would not have been able to fully benefit from economic growth in the greater region, and even less grow their market shares in some of their main export markets.


Some output in sectors that were dependent on the huge inflow of credit for growth in Latvia is apparently lost forever. The loss was inevitable, though, as lending growth came to a stop. Sectoral output loss in non-tradeable sectors cannot be a sign of lack of competitiveness. On the contrary, the exporting sectors have done very well despite the fixed exchange rate. Domestic demand also started growing again in 2011. No doubt, without the steroids growth now is more modest than the double digit rates experienced in 2005 – 2007. However, it is also more healthy and the economic tissue built and jobs created as a result of it are much more likely to be sustainable in the longer term.

Productivity growth has played a substantial role in regaining competitiveness. It is clear that the considerable increase in productivity was possible because Latvian producers and exporters were still far from the technology frontier when the crisis hit (and they still are). However, it can also be hypothesized that as a result of not taking the devaluation route there was more pressure to increase productivity fast.

Latvia continues to face major economic issues such as a relatively high debt burden in the private sector and it will probably take several more years of moderate growth before employment reaches its 2004 level, but the Latvian economy has recovered from the massive shock of 2009 faster than many of its neighbors while some other EU countries have been going in and out of recession since 2008 with no end in sight.

Because of economic differences, policies that are best for Latvia need not be best for all EU countries and would obviously not be appropriate for economies that are structurally sound and experience a cyclical weakness of demand. However, postponing an inevitable structural adjustment does not appear to be a sensible policy alternative either. There are other small, open economies with flexible labor markets that could learn from Latvia’s experience. There are also economies, such as Italy and Spain, with structural problems and labor market rigidities, which could in the longer term benefit from labor market reform as suggested by Mario Monti and others.


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