Against the Odds: Lessons from the Recovery in the Baltics

BoL/IMF conference, Riga, 5 June 2012

Gabriele Giudice

European Commission – DG ECFIN

Strong but clearly unsustainable growth

90

95

100

105

110

115

120

125

1999 2000 2001 2002 2003 2004 2005 2006 2007

LV : Domestic demand (% of GDP)

Latvia EU12 Average

EU27 GR,IE,PT,ES

-30%

-25%

-20%

-15%

-10%

-5%

0%Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

2000 2001 2002 2003 2004 2005 2006 2007

LV : Current account (% of GDP)

Current account (% of GDP)

2

Eventually, the Baltic tigers lost lustre

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2005 2006 2007 2008 2009

LV : loss of credibility

Long term government bond yields

100

110

120

130

140

150

160

170

180

190

200

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

2000 2001 2002 2003 2004 2005 2006 2007 20082009

LV : the bust

Real GDP, chain-linked 2000Q1=100

3

L-T gov. bond yields

Uncompetitive exports or unsustainable imports?

50

100

150

200

250

300

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

LV : foreign trade in constant prices (2000=100)

Imports of G&S

Export of G&S

4

30%

35%

40%

45%

50%

55%

60%

65%

70%

75%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Construction

Industry

Services

Total economy

LV : shares of Labour in GVA

How to adjust?

Prices and wages had to regain the lost ground

But also quantities and quality had to change (and devaluation would not have helped to achieve that)

Reducing the size and improving the quality was particularly necessary for the government budget

5

6

LV: QUEST II simulations for GDP % deviation, calibrated to effective consolidation, negative impact = -6%

Consolidation measures as reported by the government (Convergence Programme April 2011), % of GDP

20099.5

20104.0

20112.6

GDPchain-linked 2000Q1=100

Cumulated consolidation

(rhs)

Start of strong consolidation

A strong and frontloaded fiscal consolidation

Strong consolidation

starts in LV

HH's tot. bk deposits % growth (3-q mov. avg)

Net FDIs, flows, mil. lats, rhs(3-q mov. avg)

L-T Gov. bond yields

7

The private sector quickly responded

This likely compensated the effects of the fiscal contraction

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

2005 2006 2007 2008 2009 2010 2011

Household

consumption

Gross capital

formation

Consumer confidenceindicator

The return of confidence gave a boost to the economy, after its loss had sunk it.

(QUEST II simulations based on Latvia's data, % changes in interest rates and impact on GDP, from baseline ) -25

-20

-15

-10

-5

0

5

10

15

20

25

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2008 2009 2010 2011

Contributions to year-on-year nominal GDP growth

Exports Imports Net exports

8

"Non-Keynesian" confidence effect coming from the reversal of interest rates

And supply-side effects kicking in over time...

0%

2%

4%

6%

8%

10%

12%

14%

16%

2005 2006 2007 2008 2009 2010 2011

GROSS VALUE ADDED BY KIND OF ECONOMIC ACTIVITY (% of GDP)

(C) Manufacturing (F) Construction (O) Public administration and defence

Manufacturing

Construction and PA

9

Beyond fiscal consolidation: the EU-sponsored reform agenda

• Better use of EU funds; • Improving policies for the unemployed (100-lats program, training and vouchers,

reforming the State Employment Agency);

• State-Owned Enterprises reform; • Reforms in public administration (using ESF for public officials trainings; protection of

staff working with EU funds; merit-based motivational payments);

• Improving public procurements (EPS, centralizing procurements, ex ante checks, extra staff for the Procurement Office);

• Small Business Act (easier/cheaper to start companies);

• Improved competition policy (more resource allocated to the authority);

• Measures to attract foreign investment (Establishing a special PM-led group),

• Enhancing financial engineering instruments (MLB, LGA, Holding Fund);

• Attention to quality of spending (e.g., road construction).

Possible keys to success

• Flexibility of economy

• Rapid and decisive action

• Ownership of the programme

• Political and social sustainability

11

Some lessons

• National commitment is a must, fairness as well• Time a key dimension • Smart adjustment goes beyond an 'internal

devaluation'• Growth can return faster and adjustment can be

easier than planned, but be prudent.• Liquidity problems must not plunge an adjusting

country into insolvency 12

Against the Odds: Lessons from the Recovery in the Baltics

BoL/IMF conference Riga, 5 June 2012

Gabriele Giudice

European Commission – DG ECFIN