23.08.2010.

My view on the last 20 years in the Latvian economy, and what lies ahead

The last 20 years in the history of Latvia's economy have not been short of notable events Nevertheless, the current episode clearly stands out: the cheap credit boom lifted Latvia on top of the wave of world's fastest growing countries, while bursting of the real estate market bubble and the subsequent ebb plunged the country into the deepest crisis ever since Latvia's independence was restored. For many researchers, these economic events present valuable material for amassing experience as to what, in fact, happened and why. There is no denying that the global financial crisis has seriously affected many economies across the globe. Why was it then the Latvian economy that experienced the steepest growth and suffered from the most severe downfall?

Where is the problem?
It is interesting to note that economists in general do not necessarily view periods of buoyant growth which are followed by crisis as an unwelcome phenomenon. A number of research papers suggest a positive relationship between the degree of output volatility and the average growth rates. Though seemingly a paradox, it is possible in the economy that continuously going through the booms and busts will make a country move forward faster than slowly running along a smooth road. How is it possible? The answer lies in the country's innovative capacity, i.e. if the economy is based on creating new products and/or capturing new market niches, setbacks are inevitable but potential rewards are worth the risk.

So maybe things are not that bad in Latvia after all? Maybe high economic volatility is the price we are paying for on average higher growth to be sustained over a longer period? Unfortunately, the facts speak otherwise. Looking at the growth rates in Latvia and other East European countries since 1994, Latvia certainly takes the lead in terms of economic fluctuations: both the growth by above 12% in the years of overheating and the economic downturn by 18% in 2009 are records set by no other country but Latvia. Nonetheless, the average growth in Latvia in this period accounted for 3.9% or only slightly above the average in other East European countries. However, there are other countries that managed to achieve a similar average growth rate with much lower output fluctuations (e.g. Poland) or a similar output volatility but higher growth (e.g. Estonia); meanwhile, Slovakia has recorded simultaneously high growth (4.7% on average annually) and little volatility, void of sharp rises and falls. Thus, overall the volatile growth pattern in Latvia over the last 20 years has not contributed much to the economic development but has rather hampered it.

There are also other indicators confirming that the term "innovative economy" cannot quite be applied to Latvia of the last 20 years. Thus, for instance, the share in GDP of exports of goods (27.3%) and services (14.7%) remained at a relatively low level in Latvia in 2009, and it has not improved much since 1995. It suggests that in this period Latvia did not make any significant leap towards expanding its overall export market. Consequently, reasons underpinning the uneven development are to be sought for at home.

Who is to blame?
In search of potential culprits, many economists tend to look at the central bank. The critics claim that in the days of buoyant economic development monetary policy set by the central bank was too loose, and this resulted into a real estate bubble. A valid argument, but empirical evidence that supports this view is clearly needed. For the lack of better alternatives, here we must come and present our own estimates.  

The central question is how to assess whether the central bank's policy was consistent with the economic growth rate. In other words, were the interest rates of the last 10-15 years too low, excessively high or at an appropriate level? The most popular metric in this regard is the so called Taylor rule, which relates interest rates to the country's inflation rate and the output gap (measured as a difference between the current and long-term GDP growth rate). In case the actual money market rates exceed those estimated using the Taylor rule, the monetary policy is described as tight; if they are lower, the policy is described as expansionary.

Calculations show that until the end of 2003, interest rates in Latvia had been in line with the economic fundamentals. However, from the beginning of 2004 up to the end of 2008, interest rates were considerably lower than the economic situation of those days (soaring inflation and buoyant growth in particular) would require. The question regarding the central bank's stance during that period is: why, sensing the risks of economic overheating, didn't the central bank tighten its policy and raise interest rates? 

Here, it should be noted that loans in lats have accounted for 40%-45% of total loans already since the 1990s. With Latvia joining the European Union, loans in lats continued to contract sharply, standing at less than 10% of total loans at present. Thus the lion's share of all loans is issued in euro, with the respective interest rates set by the European Central Bank (ECB) rather than the Bank of Latvia. Quite obviously, the rates set by the ECB suited the euro area countries but were extremely low for Latvia, in light of the persisting growth differences in Latvia vis-á-vis the euro area. The Bank of Latvia can only control the lats money market, which it did via notably raising the lats interest rates on several occasions in order to curb the inflow of loans in lats into the economy. In Europe, however, free flow of capital in a fact of life, which also means people and corporations are free to change the loan currency at will. Consequently, the raising of lats interest rates has a limited impact, and, upon reaching a definite threshold, further raising becomes meaningless. If the demand for loans in lats disappears when interest rates reach, say 10 per cent, raising the rate further to 20 per cent makes no sense.

So what else can be done? Some have suggested an appreciation of the lats exchange rate against the euro. What result was to be expected in such a case? Appreciation of the national currency would have boosted the return on investment in Latvia in terms of the euro. As a result, this would have spurred the inflow of capital into Latvia, with expectations of further appreciation potentially driving the lats interest rates down in the interbank market and thereby the economy below the euro money market interest rates. Lower interest rates of the lats would have augmented the bubble, thus the outcome would have been opposite of what was expected.

Comparisons with the other East European countries are popular: they make us realise that also in several countries with floating exchange rates the interest rates have been inadequately low or even lower than in Latvia (e.g. Romania, Slovakia, etc).

It once again confirms that central bank independence to pursue monetary policy amidst the ongoing financial market globalisation in small open economies is limited irrespective of the chosen exchange rate regime. It also leaves the question about the causes of the crisis open: since other East European countries pursued a similar or even more expansionary monetary policy, why was it Latvia that was hit by the economic crisis most severely?  

Another option would be to focus on inadequate fiscal policy as a potential scapegoat. Given the limited capacity of monetary policy to curb overheating, the budgetary and tax policy had to play a more stabilizing role. This allegation can also be verified by comparing the actual budget deficit at each point with the counterfactual, assuming that fiscal policy in Latvia was pursued in full accord with the European Stability and Growth Pact. It implies there should be a budget surplus in the years of steady growth, while at times of weak economic activity a certain budget deficit could be tolerated.

These simple computations suggest that a small budget deficit was acceptable at the end of the 1990s when the Latvian economy was affected by the Russian financial crisis; in the period up to 2003, the budget had to be balanced, while in 2004 –2008, there had to be a solid budget surplus so as to minimise instability risks arising from the robust growth. But the actual situation was different: the budget was planned with a significant deficit regularly from 2000 to 2004. Even in the period of rapid growth, i.e. up to the end of 2007, budget expenditure regularly exceeded revenue.  

Thus in the last decade, the fiscal policy in Latvia was not sufficiently countercyclical. It did not stabilize the economy as much as it potentially could. Yet it would also not be appropriate to blame inadequate fiscal policy alone for all the ills. The comparison of fiscal policy pursued in a couple of last decades in Latvia and the other East European countries leads to the conclusion that it has been genuinely countercyclical only in Bulgaria and Estonia (and Estonians are benefiting from this right now). However in all other countries, Hungary, Slovakia, the Czech Republic and Poland in particular, it has been more expansionary than warranted by the underlying economic situation. Hence the question why Latvia has been hit by the crisis most severely remains unanswered. 

If monetary and fiscal policy is not the main problem, the reasons must be structural. Now I endeavour to assert that the most serious economic problem of Latvia is its globally non-competitive economic structure. Over two decades now, Latvia's economic structure is being impaired by the absence of significant, globally competitive, science-intensive industry, which accordingly implies country's chronic inability to bring competitive products to the global market.  Sure, some exceptions, even excellent ones among them, may surface, yet the overall impression is not promising. Latvian exports of goods with high value added account for mere 4.6% of total exports (12% on average from the EU countries), public and private financing for R&D annually constitutes 0.6% of GDP (2% on average in the EU countries; 1.2% in Estonia), and so on and so forth. That is why Latvia is gradually turning into the so-called "birch-besom" manufacturing economy (my apologies to besom-makers for using this fitting metaphor), sustainability of which depends, to a large extent, on lower labour costs, i.e. low wages. The moment these costs begin to increase, the producers find that exporting becomes increasingly difficult.

It is the economic structure that is, to a large extent, responsible for the severity of the current crisis. The onset of crisis could have been predicted already at the moment when the large Scandinavian banks entering the Latvian market did not find a robust and in the long term – for years or even decades – globally competitive industrial sector here in place. Thus from the banking point of view, to issue industrial credit was risky. Nevertheless, as lending is the core banking business and the industrial sector did not offer serious lending opportunities, the only source for banks to earn solid profits was lending to the real estate and construction sectors. (Banks on the whole must have been aware of the associated risks. However, each individual bnk was conceivable hoping to exit the market before the bubble bursts. Yet history suggests it does not work this way, and events in Latvia proved this once again). Implementing  appropriate and sufficiently counter-cyclical budget and tax policies could have minimised the magnitude of the bubble or made it burst sooner. Yet avoiding the bubble completely, without prohibiting or halting banking activities in Latvia, was highly unlikely.

Has this been an appropriately good lesson to learn and finally get the needed structural reforms in the economy under way? I am afraid that the array of economic recovery data masks a very significant fact: despite the improving macroeconomic indicators the banks are not keen on restarting lending. Instead, they keep enormous amounts of funds on the accounts with the Bank of Latvia at a negligible annual interest below 1%, for the Bank of Latvia has worked on making the facility as unattractive as possible. Of course, the precautionary behaviour of banks can partly stem from uncertainties of the pre-election period and concerns about the future, yet banks themselves justify it by the lack of good projects. This is as good indicator as any as to what degree of confidence the financial sector has in the long-term competitiveness of the Latvian industry. Such confidence is unlikely to emerge without cardinal changes in Latvia's economic structure. 

I shall responsibly assert that without profound changes in the structure of the economy the banks are going to either gradually exit from the Latvian market in the course of the coming 10-15 years or try to engineer another asset bubble. Under such scenario, Latvia's economy is likely to develop in accordance with a clear boom-bust pattern, with relatively slow average growth rates and little prospects of real convergence with West European countries.

What to do?

However, this scenario can be avoided, and the next government will be in a position to rectify the situation. After all, the current financial fire will be put out; there will be more time and opportunity to address fundamental growth problems; and the Bank of Latvia's economists are ready to lend a helpful hand.

In order to change the economic structure in Latvia, fundamental transformations in education are to be carried out first. Unfortunately, the current quality of labour force enables Latvia to compete more or less effectively only in the production of "birch-besoms" but does not encourage manufacturing of goods with higher value added and investment in related sectors. Moreover, highly qualified labour cannot emerge within a day, it has to be nurtured and brought up. According to the ratio of university graduates, the quality of Latvia's labour force must have been high enough to make global companies move their strategic headquarters to Latvia here and now. Albeit nothing of this kind happens as if once again refuting the conventional thinking that quantity always turns into quality. It is quite likely that allegations about inadequate public financing for Latvia's education sector are partly true, yet structural problems of the very system are also to blame. Injecting extra financing into education prior to addressing the sector's structural problems would be like carrying water from the well in the sieve.

Second, serious thought is to be given to the need for industrial policy in Latvia. Although the EU legislation imposes notable restrictions on direct state support to certain branches, indirect support is possible, and several EU countries resort to it. Latvia, so far, has not managed much more than simply to define the priority branches, with few practical steps to follow. Moreover, the priorities have been ranked and re-ranked so often that it may be hard to find sectors which have not been designated as priority at some point of time. Industrial policy drawbacks are well known, and, furthermore, one can always go wrong. Yet the experience of previous years shows that the alternative to attempt equally favourable conditions for all and then to hope for favourable coincidences that would give rise to competitive industries in Latvia is doomed to failure. Every year, the European Patent Office registers 8 patents per one million inhabitants from Latvia on average, 200 from Denmark, 250 from Finland, and 300 from Sweden. If the current attitudes persist, the probability for the "next Nokia" to emerge here in Latvia is like a million dollar jackpot win...

 


The article was published by Delfi on 17 August 2010.

APA: Bitāns, M. (2020, 23. oct.). My view on the last 20 years in the Latvian economy, and what lies ahead. Taken from https://www.macroeconomics.lv/node/1840
MLA: Bitāns, Mārtiņš. "My view on the last 20 years in the Latvian economy, and what lies ahead" www.macroeconomics.lv. Tīmeklis. 23.10.2020. <https://www.macroeconomics.lv/node/1840>.

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