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Extract3:IMFpraiseforfiscalausterityinLatvia
Latvia is one of the featured countries in the June 2014 Case Study. Click here for BBC Country Profile 
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Latvia is one of the Baltic States – the others are Estonia and Lithuania It is a small country with a total population of just over two million people. Globally it procures 0.05% of world output of goods and services It is also very small in a European Union context but a highly open economy with trade accounting for a larger share of annual GDP All three Baltic States countries joined the European Union in May 2004 as part of the largest enlargement that the EU single market has ever seen On 1st of January 2014, Latvia joined the single European currency – the 18th country to join Selection of basic statistics on the Latvian economy (Source: OECD World Economic Outlook, World Economic Forum, BBC, IMF and World Trade Organisation) 
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Population (thousands, 2012): 2,025 – there is a large Russian ethnic minority The Latvia population is declining ‐ Between 2000 and 2011; the population fell by about 13%. GDP (million current US$, 2012): $28,324 GDP (million current PPP US$, 2012): $42,471 Current account balance (million US$, 2012): ‐$473m Trade to GDP ratio (2010‐2012): 117.8% GDP (PPP) as share (%) of world total: 0.05 National minimum wage for Latvia: 200 lats (£237; 284 Euros; $392) per month Breakdown of total Latvian exports (2012) 1.
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European Union (27): 68.8 Russian Federation: 11.4 Norway: 2.6 Algeria: 2.1 Belarus: 1.8 Breakdown of total Latvian imports (2012) 1.
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European Union (27): 77.3 Russian Federation: 9.4 Belarus: 3.6 China: 2.8 Ukraine: 1.4 International competitiveness ranking 
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Global Competitiveness Index (2013): 52 out of 148 countries Latvia scored highly for ease of doing business = the government has followed pro‐private sector policies in recent years Page 52 Copyright Tutor2u tutor2u OCR F585 Case Study Toolkit for June 2014 FocusonLatvia’sExchangeRateandBalanceofPayments
Extract In December 2008 the IMF announced plans to lend €1.7 billion to Latvia to help to stabilise its economy. This financial assistance was supplemented by loans from the European Union (EU), the World Bank and several Nordic countries to provide a package totalling €7.5 billion. The assistance was part of an agreement to defend Latvia’s currency peg to the euro (a fixed exchange rate) and the country’s commitment to join the euro. The Latvian currency, the lat, had come under pressure as a result of a current account deficit on the balance of payments of almost 25% of GDP in 2007. This deficit was financed by increasing levels of private sector external debt. The credit and growth boom that followed Latvia’s accession to the EU simply could not be sustained. Very high wage growth, far in excess of productivity growth, had severely undermined Latvia’s international competitiveness and contributed to the economy’s large external imbalances. Latvia was once the fastest growing economy in the EU. By the end of 2008 it was the worst‐performing economy. What is meant by a currency peg to the Euro? 
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A currency peg is an announced fixed exchange rate, normally against a major currency like the Euro or the US dollar, but also sometimes against a basket of currencies. From January 2005 onwards the Latvian lat was pegged at 1.43 lats to the euro. The lat was left to float against the US dollar prior to Latvia joining the Euro in January 2014. A currency peg is maintained through intervention in the currency markets by a central bank. How can a central bank maintain a currency peg? If a currency is under strong selling pressure, then the central bank might decide to: 1. Raise domestic policy interest rates: Increasing interest rates will lift the expected return to short term flows of capital coming into the country’s banking system. Other things being equal, an influx of “hot money” will cause an outward shift in demand for the currency and an appreciation of the exchange rate – helping to maintain the currency peg. 2. Direct intervention: The central may also go into the currency market and intervene directly by buying up their own currency (e.g. the Latvian lat) and selling others (e.g. the Euro). This is why countries that want to stabilise the external value of their currency often have to maintain quite high reserves of foreign currencies so that intervention – if and when it happens – can be effective. 3. Legal controls: Another option – but one rarely used – is for a government to declare a fixed exchange rate and make it illegal for foreign trade in goods and services to take place at any other announced exchange rate. The main difficulty with this is that is naturally encourages black markets to emerge with unofficial exchange rates for many transactions. Page 53 Copyright Tutor2u tutor2u OCR F585 Case Study Toolkit for June 2014 As part of their currency peg against the Euro, the Latvian central bank held foreign exchange reserves to back every lats in circulation – so that there was a sufficient buffer stock. The end result was a strong surge in Latvia’s foreign exchange reserves. The value of the Latvia currency against the Euro is shown in our next chart below. Latvian Currency v The Euro
EUR/LVL
Daily exchange rate for the Lat against the Euro
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Source: International Monetary Fund
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The currency peg system against the Euro was in place for nine years from January 2005 through to Latvian accession to the Euro in January 2014. In January 2009 for example, one euro was trading at about 1.41 lats, or put another way, one lats was worth around 70 euro cents. Basically the lats was a fixed exchange rate against the Euro over this period – the currency peg was maintained, although when the global financial crisis engulfed Latvia and many other countries, there was strong pressure on the country to end their peg and allow a devaluation of the Lats by perhaps 25% or more. A key point to remember is that, although the lats/euro exchange rate was fixed, the euro itself was floating in global currency markets. So that any fall in the Euro against the US dollar or the British pound for example would bring about a similar depreciation of the lats. Page 54 Copyright Tutor2u tutor2u OCR F585 Case Study Toolkit for June 2014 Analyse how a current account deficit can put the external value of a currency under pressure A current account deficit happens when a country is running a net deficit in trade in goods and services, net investment income and net transfers. It represents an outflow of demand from the circular flow of income and spending, and a net outflow of currency from the deficit country. This deficit can be shown by an outward shift in currency supply which – other factors remaining equal – will put downward pressure on a nation’s currency value. Be able to use a currency supply and demand diagram to show this if asked in the exam The scale of Latvia’s current account deficits in the middle part of the last decade was staggering. Any country running an external deficit of more than 10% of GDP is often running into trouble, but Latvia’s balance of payments gap on the current account far exceeded even this! The figures were as follows: 
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2005: ‐12.9% of GDP 2006: ‐12.5% of GDP 2007: ‐22.5% of GDP 2008: ‐22.3% of GDP 2009: ‐13.1% of GDP 2010: +8.6% of GDP Note here the dramatic turnaround in Latvia’s current account between 2009 and 2010 How is a current account deficit financed? 
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A current account deficit essentially represents a negative balance of trade, investment income and transfers between once country and the rest of the world. The current account of the Balance of Payments can also be expressed as the difference between national (both public and private) savings and investment. A current account deficit may therefore reflect a low level of national savings relative to investment or a high rate of investment—or both. In Latvia’s case the current account deficit was the direct consequences of a consumer borrowing boom much of which was met by a surge in imports. A current account deficit is financed by the deficit country attracting foreign capital. It needs to attract a large net inflow of capital from overseas in order to balance the accounts as a whole. Where does this foreign capital come from? There are plenty of alternatives but much will depend on the economy itself – including the stage of development, the relative attractiveness of an economy to inward investment and the strength and stability of institutions such as banks, bond markets and stock markets. Foreign capital might come in from: 1. Inflows of portfolio investment into equities (shares), property and bonds 2. Short term inflows of “hot money” into a country’s banking system perhaps attracted by relatively high interest rates available on savings deposits 3. Major foreign direct investment projects such as transnational businesses launching capital investment projects or through takeover activity Page 55 Copyright Tutor2u tutor2u OCR F585 Case Study Toolkit for June 2014 What caused the credit and growth boom in Latvia after her entry into the EU in 2004? The boom was in large part the result of Latvia joining the European Union in May 2004. The decision to go ahead with EU enlargement had been made a few years earlier and one effect of this was a pre‐accession and post‐accession boom in inward investment. Businesses believed in the prospects of incomes per capita in Latvia and other Baltic States converging closer to average EU per capita incomes The boom was also fuelled by cheap interest rates on offer to consumers and businesses from foreign‐
owned banks, and a sharp rise in expectations or Keynesian animal spirits. Lower interest rates brought about a surge in house prices and in spending on consumer durables. Consider the chart below which tracks purchases of new cars in Latvia. Keep in mind that Latvia does not produce any cars of its own! Number of new cars registered per month
Latvia, New Passenger Car Registrations
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Source: Reuters EcoWin
Outline some of the consequences of a credit and growth boom such as that experienced by Latvia In the short term, the boom in real GDP growth fuelled by a money and credit surge produced some positive effects for Latvia. Unemployment fell and real living standards increased. But, like many booms in other countries, this was unbalanced expansion built on the flimsy foundations of an asset price bubble. The consequences included: 1. Inflation: A sharp increase in consumer prices inflation and a worsening of international competitiveness. Remember that Latvia was operating a fixed currency peg against the Euro, so if their inflation rate was higher than EU countries, the relative prices of Latvian products becomes more expensive Page 56 Copyright Tutor2u tutor2u OCR F585 Case Study Toolkit for June 2014 2. Bursting of the credit bubble and deep recession: The unsustainable bubble in credit came up against the start of the global financial crisis best described as a sudden credit crunch. Banks stopped lending the global economic slowdown caused a steep decline in exports from Latvia. And the economy fast descended into recession made worse by billions of euro of bad debts in the Latvian banking system. The components of the current account for Latvia are shown in the next chart. 
By far the biggest cause of the current account deficit was the huge trade deficit in goods. It reached a monthly peak of nearly 400 million lats in the summer of 2007. Net investment income for Latvia is negative, balanced out by net inflows of transfer payments. As one of Europe’s relatively poorer countries, Latvia is in receipt of structural funding from the EU budget. And sizeable net outward migration from Latvia has meant that the country also receives a flow of remittance income from Latvians living and working overseas. The country runs a small but growing surplus in trade in services Tourism is becoming an increasingly important source of growth and foreign exchange for the country. 
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Latvia - Balance of Payments - Current Account
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Latvian Lats (millions)
Monthly net balances for trade in goods, services, transfers and investment income
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Current Transfers
Source: Reuters EcoWin
Page 57 Copyright Tutor2u tutor2u OCR F585 Case Study Toolkit for June 2014 FocusonCompetitiveness
Why does fast wage growth in excess of productivity growth cause a fall in competitiveness? The key to this question is to understand that the basic measure of competitiveness is an index of relative unit labour costs (RULCs). This measures the labour cost per unit of output and is determined by two key factors – namely the rate of growth of wages and the rate of growth of labour productivity (I.e. output per person employed or output per person hour). Consider two simple numerical examples: 
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If wages are rising at 6% per year and labour productivity is growing by 3% per year, then unit labour costs will be rising by 3%. If wages are rising at 4% per year and labour productivity is growing by 5% per year, then unit labour costs will be falling by 1%. A country whose unit labour costs are increasing at a rapid rate risks losing price and competitiveness from year to year. Businesses who find that their supply costs are rising will be under pressure to raise prices to protect their profit margins and this can lead to consumers in domestic and overseas markets. Exporters for example may find that they start losing market share to suppliers in other countries whose costs are not growing as quickly. The term relative unit labour costs mean that we must also consider what is happening to unit labour costs in other countries. For example, if unit labour costs are rising by 5%in Latvia and only 2% in other EU countries, then Latvia will suffer a worsening of international competitiveness. What is meant by international competitiveness and how is it measured? International (or external competitiveness) is the ability to sell goods and services at competitive prices in a foreign country. There are two main types of competitiveness 1. Cost (price) competitiveness – differences in unit costs between producers – eventually reflected in the market prices for goods and services 2. Non‐price competitiveness – this encompasses technical factors such as product quality, design, reliability and performance, choice, after‐sales services, marketing, branding and the availability and cost of replacement parts When assessing competitiveness, non cost factors include: 
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Costs of meeting environmental / health regulations Environmental taxes e.g. carbon taxes and waste taxes Employment protection laws and health and safety laws Requirements to provide pensions for employees Each year the World Economic Forum publishes a detailed survey and ranking of countries in terms of their overall competitiveness. We will look at this when considered the competitive positions of Latvia and Iceland later on in this case study toolkit. Page 58 Copyright Tutor2u tutor2u OCR F585 Case Study Toolkit for June 2014 What is meant by an external imbalance? An external imbalance happens when there is disequilibrium in the balance of payments for a country. We normally refer only to the current account balance. To what extent did the Latvian economy experience an external imbalance? The data on Latvia’s current account is the evidence for this with deficits rising to as high as 22% of GDP and a surplus (in 2010) or more than 8% of GDP. Outline some of the effects of a high current account deficit on the balance of payments The consequences of a high current account deficit depend in part on: 
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The underlying causes of the deficit (demand and supply‐side) Whether a deficit is temporary (i.e. mainly cyclical) or persistent (i.e. a structural economic problem) Whether a country is able to finance a current account deficit i.e. by attracting foreign capital Some of the risks from running a large current account deficit are summarised in the graphic below: Loss of aggregate demand, slower growth and reduced living standards ‐ a current account deficit is a net leakage of demand in the circular flow system
Loss of jobs in home‐based industries, this may contribute to structural economic decline in certain regions / localities
Can lead to currency weakness and higher inflation and a country may run short of vital foreign currency reserves
Trade deficit is a reflection of lack of competitiveness / supply‐side weaknesses
When the global financial crisis engulfed most of the European Union, Latvia suffered from capital flight, a deep recession and a growing fiscal deficit (as unemployed soared). Eventually Latvia was forced to ask for emergency help and this involved a bail‐out from the IMF, the World Bank, the EU and other countries. Page 59 Copyright Tutor2u tutor2u OCR F585 Case Study Toolkit for June 2014