The Baltic Times today had this article about the latest Eurobarometer findings on the Baltics:
Three years on from the euphoric scenes that accompanied the Baltic States’ accession to the EU, Balts have become much more varied in their attitude to Brussels, according to a new survey.
The annual Eurobarometer survey includes responses from more than 1,000 citizens of each Baltic State, and reveals some trends that will be of major concern to national and european institutions. Asked whether or not they believed that their country’s membership of the EU is a good thing, Estonians rank among the most europhile countries with 66 percent believing that it is. Lithuanians are slightly more sanguine at 63 percent, whereas Latvians are among the most euroskeptic countries with just 37 percent giving the EU their unqualified backing. A larger number of Latvians – 46 percent – are of the opinion that the EU is neither good nor bad, displaying a ‘take it or leave it’ attitude that should cause eurocrats to sit up and take notice. However, the report’s authors are quick to lay the blame for the crisis in Latvian confidence a long way from Brussels: “Latvian respondents’ attitude to the EU became more negative reflecting dissatisfaction with Latvian domestic issues,” they say.
“The increasingly optimistic trends in Latvia shown in the last few surveys are not apparent in the latest survey.” That conclusion seems to be borne out by news that the level of trust in the Latvian national government has decreased dramatically by 12 percentage points to just 20 percent, well below the EU average. The survey suggests that differences between the Baltic States’ attitudes are growing. Estonia has changed from being the most euroskeptic country to the most europhile. Lithuania, in the past year and a half, had become more negative towards the EU, but now is becoming more positive and has reached the same level as when Lithuania joined the EU. In Latvia there has been an increase in negative attitudes turning it into the third most euroskeptic country in the EU, behind the UK and Austria.
Monday, July 30, 2007
Thursday, July 26, 2007
Latvian External Trade
I am going to track the monthly changes in the Latvian trade balance to get some idea where we are going. There is not too much to read into what we see below, except, of course, that imports are still running at a lot higher level than exports.
However, for the Latvian government strategy to be successful, both in containing the internal demand and maintaining economic growth, we should see imports come down and exports go shooting up. This has to be the objective, although without devaluation I simply can't see how they are going to do it. Still, lets wait and see.
Source Latvijas Statistika (and here)
However, for the Latvian government strategy to be successful, both in containing the internal demand and maintaining economic growth, we should see imports come down and exports go shooting up. This has to be the objective, although without devaluation I simply can't see how they are going to do it. Still, lets wait and see.
Source Latvijas Statistika (and here)
Credit Growth and the CA Deficit
The following charts showing Latvia's deteriorating current account position and annual rates of credit growth come from The Global Financial Accelerator and the role of International Credit Agencies, a Paper presented to the International Conference of Commercial Bank Economists, Madrid, July 2007 by Carsten Valgreen, Chief Economist, Danske Bank
As Carsten says:
Latvia has successfully run a fixed exchange rate regime in recent years with the euro as the anchor. The fixed exchange rate regime has naturally diminished monetary policy’s ability to play a stabilising role in the economy. However, since 2005, the boom has accelerated and changed character. Increasingly it has been driven by the construction sector and the housing market, leading to extreme credit growth, rising inflation and above 25% wage growth.The fixed exchange rate regime has prevented the central bank from tightening monetary policy, and fiscal policy has not really been tightened either. Interestingly, external funding – which in theory should react to the overheating by tightening – has continued to be ample.
Partly this is because foreign banks own the largest banks in Latvia. These banks have continued to compete for market share in what is seen as a long-term growth market, by aggressively promoting credit. Foreign banking corporations fund a large part of Latvia’s current account deficit through their Latvian subsidiaries. Also, speculative funding in low rate foreign currencies has become widespread, cf. chart 4 above. Effectively this has led to a situation where the Latvian central bank had very little influence on credit extension in Latvia. Effectively foreign banks have extended credit in foreign currency to Latvian households and companies, keeping Latvian monetary policy and the central bank out of the loop. In spring 2007, this led to some pressure on the Latvian lati. This was partly ignited by Standard & Poor’s downgrade of Latvia’s sovereign debt. The central bank was forced to defend the currency by selling reserves. Partly this was also fuelled by Latvian politicians being seen to be postponing EMU entry, and by their unwillingness to tighten the fiscal reins. However, generally global markets have proved surprisingly complacent about the situation in Latvia, as is the case in Iceland.
As Carsten says:
Latvia has successfully run a fixed exchange rate regime in recent years with the euro as the anchor. The fixed exchange rate regime has naturally diminished monetary policy’s ability to play a stabilising role in the economy. However, since 2005, the boom has accelerated and changed character. Increasingly it has been driven by the construction sector and the housing market, leading to extreme credit growth, rising inflation and above 25% wage growth.The fixed exchange rate regime has prevented the central bank from tightening monetary policy, and fiscal policy has not really been tightened either. Interestingly, external funding – which in theory should react to the overheating by tightening – has continued to be ample.
Partly this is because foreign banks own the largest banks in Latvia. These banks have continued to compete for market share in what is seen as a long-term growth market, by aggressively promoting credit. Foreign banking corporations fund a large part of Latvia’s current account deficit through their Latvian subsidiaries. Also, speculative funding in low rate foreign currencies has become widespread, cf. chart 4 above. Effectively this has led to a situation where the Latvian central bank had very little influence on credit extension in Latvia. Effectively foreign banks have extended credit in foreign currency to Latvian households and companies, keeping Latvian monetary policy and the central bank out of the loop. In spring 2007, this led to some pressure on the Latvian lati. This was partly ignited by Standard & Poor’s downgrade of Latvia’s sovereign debt. The central bank was forced to defend the currency by selling reserves. Partly this was also fuelled by Latvian politicians being seen to be postponing EMU entry, and by their unwillingness to tighten the fiscal reins. However, generally global markets have proved surprisingly complacent about the situation in Latvia, as is the case in Iceland.
Foreign Currency Lending and Central Bank Options
The following chart comes from The Global Financial Accelerator and the role of International Credit Agencies, a Paper presented to the International Conference of Commercial Bank Economists, Madrid, July 2007 by Carsten Valgreen, Chief Economist, Danske Bank
This data is from 2005, and the position since that time can only have changed in the direction of increased dependence (at least in those countries who started from a low base). This makes the risk level coming from any currency adjustment very clear.
The following is a summary of the content of Carsten's paper:
The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of hard currency” economies based on foreign fiat money or gold.
The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.
Here is a summary of the sort of financial transaction which might have been going on in a little corner bank branch, somewhere near you:
Take an arbitrary example: A Polish household wants to buy a second home in France. To do this they contact their local bank (which happens to be the subsidiary of a Swedish-based banking corporation) in order to obtain mortgage finance. They then choose to borrow the money in Swiss francs and Japanese yen. This action is likely to have a large impact on the future income streams and net asset value of this Polish household, and – hence – its future behaviour in the real economy. However, as long as free capital flows are maintained the Polish central bank has limited influence on the transaction. None of it is in Polish zloty. And the credit decision of the private banking corporation extending the credit is taken based on a credit model maintained in Stockholm in Sweden. What will matter for the family is the future currency and rate moves in Swiss francs and Japanese yen. And the price developments for second homes in France. And perhaps also the future credit attitude of a Swedish-based credit institution.
This data is from 2005, and the position since that time can only have changed in the direction of increased dependence (at least in those countries who started from a low base). This makes the risk level coming from any currency adjustment very clear.
The following is a summary of the content of Carsten's paper:
The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of hard currency” economies based on foreign fiat money or gold.
The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.
Here is a summary of the sort of financial transaction which might have been going on in a little corner bank branch, somewhere near you:
Take an arbitrary example: A Polish household wants to buy a second home in France. To do this they contact their local bank (which happens to be the subsidiary of a Swedish-based banking corporation) in order to obtain mortgage finance. They then choose to borrow the money in Swiss francs and Japanese yen. This action is likely to have a large impact on the future income streams and net asset value of this Polish household, and – hence – its future behaviour in the real economy. However, as long as free capital flows are maintained the Polish central bank has limited influence on the transaction. None of it is in Polish zloty. And the credit decision of the private banking corporation extending the credit is taken based on a credit model maintained in Stockholm in Sweden. What will matter for the family is the future currency and rate moves in Swiss francs and Japanese yen. And the price developments for second homes in France. And perhaps also the future credit attitude of a Swedish-based credit institution.
Hansapank in the Baltics
One of the topics which is rapidly becoming clear is that one of the banks which is most exposed to any correction in the Baltics is the Swedish AS Hansapank. According to Bloomberg this morning:
The governments of the Baltic states of Lithuania, Latvia and Estonia aren't doing enough to counter threats to economic growth, according to AS Hansapank, the biggest lender in the three countries.Tallinn, Estonia-based Hansapank cited a ``lack of policies aimed at limiting the risks of overheating'' in Lithuania and a ``contradictory'' budget policy in Estonia.
``The major risks we see are government economic policies, while current global economic developments are favorable in general,'' Hansapank Chief Economist Maris Lauri said in an e- mailed quarterly Baltic Outlook report.
The lender called for a budget surplus this year in Latvia ``to support a soft landing.'' The Latvian government plans to balance the budget in 2007, after having planned for a deficit of 1.4 percent of gross domestic product.
All of this may very well be true, but as indicated in the recent BICEPS report these governments now have very little policy room to play around with.
The governments of the Baltic states of Lithuania, Latvia and Estonia aren't doing enough to counter threats to economic growth, according to AS Hansapank, the biggest lender in the three countries.Tallinn, Estonia-based Hansapank cited a ``lack of policies aimed at limiting the risks of overheating'' in Lithuania and a ``contradictory'' budget policy in Estonia.
``The major risks we see are government economic policies, while current global economic developments are favorable in general,'' Hansapank Chief Economist Maris Lauri said in an e- mailed quarterly Baltic Outlook report.
The lender called for a budget surplus this year in Latvia ``to support a soft landing.'' The Latvian government plans to balance the budget in 2007, after having planned for a deficit of 1.4 percent of gross domestic product.
All of this may very well be true, but as indicated in the recent BICEPS report these governments now have very little policy room to play around with.
Wednesday, July 25, 2007
Second Quarter Latvian Inflation
According to the Baltic Times:
Inflation at the producer level in Latvia continues unabated in the second quarter of 2007, increasing by 4.4 percent compared to the first quarter, and showing an increase of 17.8 percent year-on-year, according to Latvia’s Central Statistics Office.
The largest increase in costs from the first to second quarters of this year was in the production of non-metallic goods, registering an increase of 11.5 percent; next came water cleansing producer prices which rose by 6.1 percent, followed by rubber and plastic goods production prices up by 5.6 percent, and production prices for timber and timber products, except furniture, increasing by 5 percent. Producer prices declined in garment manufacturing and fur processing and painting as well as in the printing and sound recording industries by 2.2 percent and 0.8 percent, respectively.
Compared to May 2007, the overall month-on-month producer price level rose by 0.4 percent for June, while the year-on-year increase for the month was 17.7 percent. Compared to May 2007, the overall month-on-month producer price level for domestically sold goods grew by 0.9 percent but for goods exported to foreign markets a decline in producer prices of 0.2 percent was registered. The year-on-year increase in March at the producer price level for domestically sold goods reached 18.8 percent but for goods exported to foreign markets, by 16.1 percent.
This trend, whilst being fairly predictable, is rather depressing. But it is more or less as forecast in the BICEPS report.
Inflation at the producer level in Latvia continues unabated in the second quarter of 2007, increasing by 4.4 percent compared to the first quarter, and showing an increase of 17.8 percent year-on-year, according to Latvia’s Central Statistics Office.
The largest increase in costs from the first to second quarters of this year was in the production of non-metallic goods, registering an increase of 11.5 percent; next came water cleansing producer prices which rose by 6.1 percent, followed by rubber and plastic goods production prices up by 5.6 percent, and production prices for timber and timber products, except furniture, increasing by 5 percent. Producer prices declined in garment manufacturing and fur processing and painting as well as in the printing and sound recording industries by 2.2 percent and 0.8 percent, respectively.
Compared to May 2007, the overall month-on-month producer price level rose by 0.4 percent for June, while the year-on-year increase for the month was 17.7 percent. Compared to May 2007, the overall month-on-month producer price level for domestically sold goods grew by 0.9 percent but for goods exported to foreign markets a decline in producer prices of 0.2 percent was registered. The year-on-year increase in March at the producer price level for domestically sold goods reached 18.8 percent but for goods exported to foreign markets, by 16.1 percent.
This trend, whilst being fairly predictable, is rather depressing. But it is more or less as forecast in the BICEPS report.
The Phillips Curve In Latvia
The Latvian National Bank have a new working paper out, on guess what, the Philips curve. This is issue is hardly surprising given the labour supply and inflation issues which exist right now. Now aside from a lot of theoretical "hocus pocus" and equations etc, some things of interest do stand out:
Estimation of the Phillips Curve For Latvia
Aleksejs Meļihovs and Anna Zasova
Of late, trend inflation issues are gaining importance in Latvia as well. Nowadays,
with the rate of inflation (including also core inflation) soaring, understanding the
inflation formation mechanism and the reasons of persisting inflationary pressures in
the country is particularly crucial.
The job-seekers ratio to economically active population (from Latvia's labour surveys) has been used as an indicator of unemployment. This indicator reflects the situation in the labour market more accurately than does the registered unemployment rate, because it covers also people who are looking for work on their own and do not apply to the State Employment Agency.......
Model results suggest that around 50% of Latvian companies form adaptive inflation expectations or are backward-looking, whereas the average time between two consecutive price adjustment events is around 6 months. The comparison of the study results with similar outcomes from papers on the euro area and the US enabled the authors to conclude that the behaviour of economic agents in Latvia is notably different. First, companies with rational expectations or those that are forwardlooking prevail in both the euro area and the US. Second, the expected time for prices to remain constant in Latvia is considerably shorter than in the euro area (3 years) and the US (1.5 years).
In Latvia, inflation expectations are an important factor affecting the actual inflation rate. Moreover, quite frequent output price adjustments in Latvia imply that changes in inflation expectations would relatively soon pass through to actual prices in Latvia. Model results suggest that around a half of all Latvian companies are forward-looking, implying that they are forming their inflation expectations on the basis of information about those economic fundamentals that may have implications for price changes in the future. It leads to an inference that timely and broadly-based information about the expected inflation dynamics and changes in it supplied to the companies would lower inflation expectations and, consequently, also the actual inflation rate. Simultaneously, the comparatively large number of companies with adaptive inflation expectations in Latvia adds to the persistence of overall inflation expectations in the country and renders the task of reducing inflation expectations more complicated.
Estimation of the Phillips Curve For Latvia
Aleksejs Meļihovs and Anna Zasova
Of late, trend inflation issues are gaining importance in Latvia as well. Nowadays,
with the rate of inflation (including also core inflation) soaring, understanding the
inflation formation mechanism and the reasons of persisting inflationary pressures in
the country is particularly crucial.
The job-seekers ratio to economically active population (from Latvia's labour surveys) has been used as an indicator of unemployment. This indicator reflects the situation in the labour market more accurately than does the registered unemployment rate, because it covers also people who are looking for work on their own and do not apply to the State Employment Agency.......
Model results suggest that around 50% of Latvian companies form adaptive inflation expectations or are backward-looking, whereas the average time between two consecutive price adjustment events is around 6 months. The comparison of the study results with similar outcomes from papers on the euro area and the US enabled the authors to conclude that the behaviour of economic agents in Latvia is notably different. First, companies with rational expectations or those that are forwardlooking prevail in both the euro area and the US. Second, the expected time for prices to remain constant in Latvia is considerably shorter than in the euro area (3 years) and the US (1.5 years).
In Latvia, inflation expectations are an important factor affecting the actual inflation rate. Moreover, quite frequent output price adjustments in Latvia imply that changes in inflation expectations would relatively soon pass through to actual prices in Latvia. Model results suggest that around a half of all Latvian companies are forward-looking, implying that they are forming their inflation expectations on the basis of information about those economic fundamentals that may have implications for price changes in the future. It leads to an inference that timely and broadly-based information about the expected inflation dynamics and changes in it supplied to the companies would lower inflation expectations and, consequently, also the actual inflation rate. Simultaneously, the comparatively large number of companies with adaptive inflation expectations in Latvia adds to the persistence of overall inflation expectations in the country and renders the task of reducing inflation expectations more complicated.
Latvian Population Dynamics
I seem to be having a Latvia week. I gave a long post on Global Economy Matters analysing the current serious wage and price inflation problem the country is having, and a shorter summary post (more accessible if you are not an economist) on A Fistful of Euros which really tries to draw attention to why the problems this comparatively small country (population around 2 million) is having may be significant and interesting for people to think about in a much more general context.
The issue is labour supply and economic growth (what Claus and I call the "capacity problem"), and how a very tight labour supply in Latvia is producing an astronomical 33% annual increase in wages. The problem is basically how a society which has experienced strong out-migration and lowest-low fertility during an extended period can sustain strong economic "catch up" growth (which of course all the Eastern European societies need if they are to come anywhere near the per capita incomes of Western Europe) given the constraint that is produced on new labour market entrants.
Basically, economies can grow in one of two ways. They can either grow horizontally (by expanding economic activity in existing product categories) or the can grow vertically (by moving up the value chain). The problem is that it is a lot more difficult to achieve rapid vertical growth in a short period of time, since moving into new economic activities is, by its very nature, a comparatively slow process given that new human capital needs to be formed, experience needs to be gained, and learning-by-doing needs to take place. Thus bottlenecks inevitably arrive (Indian outsourcing growth would be one good current example of this issue). So during the initial periods of catch-up growth it is normal that horizontal growth plays an important part (this process is what economists tend to call the initial accumulation of inputs). This was clearly the experience, for example, in the classic case of the Asian tigers, were it is clear that strong productivity driven growth only took place at a later stage (China may now be about to become another example of this).
But the problem for countries like Latvia is they do not have the latent human resources to really get the benefits from this "inputs accumulation" process. At comparison of the Latvian projected population pyramid changes 2006-2025, and the Irish one 1986-2000 (which I have put up here) may help make this clearer.
What follows below is an edited version of the demographic component of my Global Economy Matters post. I think it is also important to note that - as Claus points out in this post - this tendency, which is now making its presence felt in Latvia will soon extend across Eastern Europe and Central Asia, (you can find a chart showing the labour force change projections for these countries between now and 2025 here). All of this takes on a certain importance when we think about the kinds of issues we were discussing in the Polish context (here), and if we look at the present rate of decrease in Polish unemployment. Poland's unemployment rate fell in May 2007 to 13 percent, and this was a decrease of 23% in one year (and Polands economy, remember is "only" growing by 6.5% a year). If this process continues, Poland will have an unemployment rate of 9% in May 2008, 7% in May 2009, 5% in May 2010, and 4% or below in 2011. So within 4 years Poland could hit a growth-constraint wall. This is all remarkably rapid indeed. Of course, growth may falter, but in which case it is hard to see how Poland can ever catch up with Western Europe. This is a race against time in some ways, before a window of opportunity closes.
Russia itself is already feeling the pinch, and out further East Azerbaijan's economy is growing at 35% a year. In the Russian case, John Litwack, the World Bank's chief economist in Moscow, estimates that Russia is going to need about a million migrants a year.
To compensate for this(the labour force decline, EH), Russia would need an annual inflow of 1 million immigrants, which is three times as the average official annual flowover the last 15 years, and five times the official flowin recent years.
Latvia, Fertility, Migration and the Labour Supply
So how big is Latvia's demographic problem? Well to try and get some sort of appreciation of the order of magnitude here we could think about the fact that during 2006 Latvian employment was increasing at an annual rate of around 70,000, while if we look at live births for a moment, we will see that since the early 1990s Latvia has been producing under 40,000 children annually (by 2006 this number is down to 21,000 (as the chart below makes clear).
Indeed ex-migrant flows, the Latvian population is now falling (by 0.648% annually according to the 2007 edition of the CIA World Factbook), and at a significant rate (the birth rate is at a very low level, 1.3TFR in 2006 according to the Population Reference Bureau). Taking into account uncertainties about out-migration (which is almost certainly greater then is reflected in the official statistics) in fact the rate of decline might be even greater.
At the same time the internal employment situation is becoming ever tighter, with unemployment levels becoming ever lower (see chart below, data 2005, and Q1 2005 through Q3 2006).
(please click over image for better viewing)
As can be seen in Q3 2006, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2%. Put another way, an increase in employment of some 75,000 had produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn't take sophisticated mathematics - or "robust" models - to see that this cannot last.
One solution is obviously to try and increase the level of labour market participation, but - and it is interesting that almost no-one here seems to be talking about the need for labour market reforms - it is hard to estimate just how much potential in reality there still is for this. According to the Latvia Statistical Agency Q2 2006 labour force report:
In Q2 2006 more than a half (63.8%) of residents in the age from 15 to 74 were economically active – this indicator was 68.9% amongst males, and 59.4% amongst females. in the 2nd quarter of 2006, the number of economically active population, in comparison with the corresponding period of 2005, increased by 2%.
These numbers, since they include everyone up to 74, and many under 20 - an age where education may still be taking place in many cases - are really very hard to interpret. But whichever way you look at it there is certainly a problem, since wage increases of this order would normally be considered to motivate more labour to come into the market, were it available. However, before going into this labour market structural bind in greater depth, let's take a look at some more of the details of the general economic dilemma.
Migration As A Solution?
Well given that a strategy of relying exclusively on fiscal tightening and strong deflation (as is being recommended to the Latvian government by a variety of sources) is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints somewhat via an open-the-doors policy towards inward migration and with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.
However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these is that such a process may ultimately put downward pressure on unskilled Latvian workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a “slightly positive” impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.
A further difficulty is the lack of availability of accurate data on the actual scale of either inward or outward migration in Latvia (this difficulty is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad - mostly in the UK and Ireland - but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).
Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latvia’s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either “very likely” or “somewhat likely” to go to another country for work “in the next two years”. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.
But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table below.
(please click over image for better viewing)
Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.
In fact, if we look at the chart below, we will see that during 2003 the rate of out migration from Latvia seems to have dropped substantially, and given what we know about the post 2004 out migration boom, this, on the surface, seems strange.
(please click over image for better viewing)
The answer to this puzzle is to do with the Russophone population who are not Latvian citizens (and therefore logically at this point not EU citizens either). The majority of the pre 2004 out-migration was actually towards the CIS, and it is reasonable to assume that many of these migrants came from the Russian speaking population. And this process is not over as this recent article from Itar-Tass about a joint project to settle Russian speaking Latvian residents in Kaliningrad makes clear.
So clearly the fact that the Latvian authorities may still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere gives an indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.
Yet one more time the difference with Estonia couldn't be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals - which before Parliament by November - which will attempt to address Estonia’s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start, and it is one that Latvia has yet to make.
The issue is labour supply and economic growth (what Claus and I call the "capacity problem"), and how a very tight labour supply in Latvia is producing an astronomical 33% annual increase in wages. The problem is basically how a society which has experienced strong out-migration and lowest-low fertility during an extended period can sustain strong economic "catch up" growth (which of course all the Eastern European societies need if they are to come anywhere near the per capita incomes of Western Europe) given the constraint that is produced on new labour market entrants.
Basically, economies can grow in one of two ways. They can either grow horizontally (by expanding economic activity in existing product categories) or the can grow vertically (by moving up the value chain). The problem is that it is a lot more difficult to achieve rapid vertical growth in a short period of time, since moving into new economic activities is, by its very nature, a comparatively slow process given that new human capital needs to be formed, experience needs to be gained, and learning-by-doing needs to take place. Thus bottlenecks inevitably arrive (Indian outsourcing growth would be one good current example of this issue). So during the initial periods of catch-up growth it is normal that horizontal growth plays an important part (this process is what economists tend to call the initial accumulation of inputs). This was clearly the experience, for example, in the classic case of the Asian tigers, were it is clear that strong productivity driven growth only took place at a later stage (China may now be about to become another example of this).
But the problem for countries like Latvia is they do not have the latent human resources to really get the benefits from this "inputs accumulation" process. At comparison of the Latvian projected population pyramid changes 2006-2025, and the Irish one 1986-2000 (which I have put up here) may help make this clearer.
What follows below is an edited version of the demographic component of my Global Economy Matters post. I think it is also important to note that - as Claus points out in this post - this tendency, which is now making its presence felt in Latvia will soon extend across Eastern Europe and Central Asia, (you can find a chart showing the labour force change projections for these countries between now and 2025 here). All of this takes on a certain importance when we think about the kinds of issues we were discussing in the Polish context (here), and if we look at the present rate of decrease in Polish unemployment. Poland's unemployment rate fell in May 2007 to 13 percent, and this was a decrease of 23% in one year (and Polands economy, remember is "only" growing by 6.5% a year). If this process continues, Poland will have an unemployment rate of 9% in May 2008, 7% in May 2009, 5% in May 2010, and 4% or below in 2011. So within 4 years Poland could hit a growth-constraint wall. This is all remarkably rapid indeed. Of course, growth may falter, but in which case it is hard to see how Poland can ever catch up with Western Europe. This is a race against time in some ways, before a window of opportunity closes.
Russia itself is already feeling the pinch, and out further East Azerbaijan's economy is growing at 35% a year. In the Russian case, John Litwack, the World Bank's chief economist in Moscow, estimates that Russia is going to need about a million migrants a year.
To compensate for this(the labour force decline, EH), Russia would need an annual inflow of 1 million immigrants, which is three times as the average official annual flowover the last 15 years, and five times the official flowin recent years.
Latvia, Fertility, Migration and the Labour Supply
So how big is Latvia's demographic problem? Well to try and get some sort of appreciation of the order of magnitude here we could think about the fact that during 2006 Latvian employment was increasing at an annual rate of around 70,000, while if we look at live births for a moment, we will see that since the early 1990s Latvia has been producing under 40,000 children annually (by 2006 this number is down to 21,000 (as the chart below makes clear).
Indeed ex-migrant flows, the Latvian population is now falling (by 0.648% annually according to the 2007 edition of the CIA World Factbook), and at a significant rate (the birth rate is at a very low level, 1.3TFR in 2006 according to the Population Reference Bureau). Taking into account uncertainties about out-migration (which is almost certainly greater then is reflected in the official statistics) in fact the rate of decline might be even greater.
At the same time the internal employment situation is becoming ever tighter, with unemployment levels becoming ever lower (see chart below, data 2005, and Q1 2005 through Q3 2006).
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As can be seen in Q3 2006, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2%. Put another way, an increase in employment of some 75,000 had produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn't take sophisticated mathematics - or "robust" models - to see that this cannot last.
One solution is obviously to try and increase the level of labour market participation, but - and it is interesting that almost no-one here seems to be talking about the need for labour market reforms - it is hard to estimate just how much potential in reality there still is for this. According to the Latvia Statistical Agency Q2 2006 labour force report:
In Q2 2006 more than a half (63.8%) of residents in the age from 15 to 74 were economically active – this indicator was 68.9% amongst males, and 59.4% amongst females. in the 2nd quarter of 2006, the number of economically active population, in comparison with the corresponding period of 2005, increased by 2%.
These numbers, since they include everyone up to 74, and many under 20 - an age where education may still be taking place in many cases - are really very hard to interpret. But whichever way you look at it there is certainly a problem, since wage increases of this order would normally be considered to motivate more labour to come into the market, were it available. However, before going into this labour market structural bind in greater depth, let's take a look at some more of the details of the general economic dilemma.
Migration As A Solution?
Well given that a strategy of relying exclusively on fiscal tightening and strong deflation (as is being recommended to the Latvian government by a variety of sources) is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints somewhat via an open-the-doors policy towards inward migration and with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.
However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these is that such a process may ultimately put downward pressure on unskilled Latvian workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a “slightly positive” impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.
A further difficulty is the lack of availability of accurate data on the actual scale of either inward or outward migration in Latvia (this difficulty is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad - mostly in the UK and Ireland - but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).
Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latvia’s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either “very likely” or “somewhat likely” to go to another country for work “in the next two years”. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.
But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table below.
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Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.
In fact, if we look at the chart below, we will see that during 2003 the rate of out migration from Latvia seems to have dropped substantially, and given what we know about the post 2004 out migration boom, this, on the surface, seems strange.
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The answer to this puzzle is to do with the Russophone population who are not Latvian citizens (and therefore logically at this point not EU citizens either). The majority of the pre 2004 out-migration was actually towards the CIS, and it is reasonable to assume that many of these migrants came from the Russian speaking population. And this process is not over as this recent article from Itar-Tass about a joint project to settle Russian speaking Latvian residents in Kaliningrad makes clear.
So clearly the fact that the Latvian authorities may still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere gives an indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.
Yet one more time the difference with Estonia couldn't be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals - which before Parliament by November - which will attempt to address Estonia’s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start, and it is one that Latvia has yet to make.
Is The Latvian Economy Running Out Of People?
Something is afoot in Latvia. Being alerted by reports which have appeared in the press in recent days to the very rapid rate of wage increases they have been experiencing there I decided to dig a little deeper, and in the process I came across this recent IMF statement on Latvia, where I read the following:
"Latvia, like other recent EU entrants, has benefited from an accession-related boost to income convergence....."Recently, however, fast credit and wage growth has caused the economy to diverge from a balanced and sustainable growth path, with domestic demand outstripping Latvia's supply capacity. As a result, overheating has intensified, bringing higher price and wage inflation, a sharply wider current account deficit, and greater external indebtedness. Rapid credit growth in euros has left large currency mismatches on the balance sheets of households and corporates and a boom in housing prices that has diverted resources from the tradable sector. A pervasive "buy now-pay later" mindset has settled in and is heightening systemic risk. These developments, if not tackled firmly, will thwart a recovery of export growth."
"There is an urgent need for decisive action to unwind overheating pressures and narrow external imbalances by sharply curtailing domestic demand. Notwithstanding actions by the Bank of Latvia to raise risk awareness, recent pressure on the lats signals growing investor impatience with the limited policy response so far. A comprehensive strategy is therefore needed to curb domestic spending and wage growth, and moderate real estate prices to rebalance incentives for investing in tradables sectors."
What now follows is a long (very long, even by my recent standards) post which examines the core features of Latvia's current economic malaise. It is generally recognised by most external observers that this malaise has its origins in structural problems in the Latvian labour market, and it will be argued here that these structural problems have their roots in recent characteristics of Latvian demography (namely high out-migration and a sustained low birth rate). As such there is no easy solution. Even in the longer run the position will inevitably be difficult, since demography almost inevitably casts a long shadow. This does not mean, however, that we should be complacent. There are steps which can be taken to address the issues which Latvia faces in the short term, and it is important that such appropriate measures are enacted. These measures clearly include policies to reduce the dramatic overheating which is taking place, but they also should include policies to loosen the labour supply, not only by encouraging increased labour market participation and mobility, but also by actively encourage inward migration. Such policies may be seen as short term measures which are vital to move Latvia away from an unsustainable and towards a sustainable economic path.
The Measure of the Problem
As I have said, and previously noted in this post, according to the latest Eurostat data, wages and salaries in Latvia rose in Q1 (as compared with a year earlier) by an astonishing 32.7%. This rate of increase is, in and of itself a symptom of something important, and is clearly unsustainable.
For a simple coverage of recent developments this recent Bloomberg article gives a useful summary of the underlying dynamic involved.
According to Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics (in this BICEPS report) "Latvia's inflation, the fastest in the European Union, will continue to erode the competitiveness of the country's' exports as it shows no sign of slowing"
In fact Latvia's inflation rate (CPI, see Graph below) reached a 10-year high of 8.9 percent in April 2007, largely driven by growth in wages and producer-prices.
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As a consequence of this wage and price growth the competitiveness of Latvia's exporters has been so eroded, and the trade balance so negatively affected (see graph below), that the economy is now destined either to go through a very long period of deflation, or to undergo a substantial devaluation of the currency in order to put the ship back on an even keel. But if the Latvian government were to opt for the latter course we would hit a problem, since the traditional route for correcting such a deficit - letting a currency freely float (the Lats has been loosely pegged* to the Euro since early 2005) and raising interest rates - is not so obviously open here. In today's perverse world of global liquidity and international capital flows it could well be that any increase in central bank interest rates would simply suck-in even more funds in a steady and ongoing search for yield. Appetite for risk might not be reduced by the appearance of non-sustainability since - and this would be the big initial difference from say Turkey in 2006 - the EU and the ECB are ultimately seen as guarantors of the last resort for the Latvian economy. So effectively the situation could turn into a battle of wills between speculators looking for yield and the EU institutional structure.
( *The Latvian currency, the Lats, is allowed to move by plus or minus 1 percent around a midpoint against the euro. The lats is currently worth somewhere around 1.43 euro).
As can be seen from the graph below, Latvia's current-account deficit has more than doubled over the last two years, and the quarterly current-account deficit, for example, grew from around 10% of GDP in Q1 2005 to 26% of GDP in Q1 2006.
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Thus Latvia now has the somewhat dubious merit of having the fastest growing economy, the highest inflation, and largest current-account deficit in the 27-nation EU. Since the country has a fixed exchange rate (which could be made more flexible, although, as we will, doing this in itself raises as many problems as it could solve, since the currency could just as easily be lead to float up as down), and raising interest rates may well only draw even more liquidity into an economy where the majority of consumer credit expansion is now in non-Lats denominated loans (70% of domestic credit is now denominated in euros), the Latvian government is really only left with fiscal policy as the major instrument with which to try to correct the growing internal and external imbalances.
As Lars Christensen, senior economist at A/S Danske Bank (who is quoted by Bloomberg) says: "Money supply and credit growth have created a property bubble. What has fueled growth and credit has been cheap liquidity, globally rather than locally."
An Anti Inflation Programme?
So what do we have here? Well, despite considerable talk and concern, the inflation problem in Latvia has not gone away in recent months, if anything has intensified. The Latvian government do seem to be as concerned as anyone, and on the back of the problem have set up a working group on inflation, which published its current anti-inflation plan in March, and which, according to the Bank of Lavia, "continues to monitor the situation". Despite strong prodding from the IMF, the aims of Latvian government policy as contained in the report - and summarized by the Finance Ministry here - are surprisingly modest given the severity of the situation, namely:
i) to maintain a balanced budget (ie, neither deficit nor surplus) for 2007, and attempt to attain a surplus by 2009/10.
ii) to impose a real estate tax on properties sold which have been owned for less than 3 years;
iii) to attempt to make it more difficult to obtain credit by, for example, requiring commercial banks and leasing companies to better determine the purchasing power of customers and to make loans available exclusively on the legal income of clients;
iv) to exercise better control over energy prices
v) to introduce measures aimed at increasing labour market participation and increasing productivity, as well as product-market-competition reforms. As the summary says, these last items are by their very nature long term, and as such hardly appear to form a core part of the "crisis" short term package.
All in all then, an extraordinarily relaxed programme it would seem under the circumstances.
Now (as indicated above) both wages (32.8% growth y-o-y in Q1 2007) and producer prices (16% - 18% growth y-o-y in early 2007) have been accelerating recently with wage growth being estimated to feed into producer prices with a lag of approximately 15 months. This increase in producer prices in turn then feeds into export prices, and the consequence is a continuing and sustained loss of international competitiveness.
Now the existence of this evident feed through between wages and producer prices means that there is now a wide consensus (both inside Latvia itself and among international observers) that the inflation problem cannot be addressed separately from the imbalances which exist in Latvia's internal labour market (imbalances to which outward migration in the early years of this century and many years of below replacement fertility - see below - have contributed in no small way). Since the recent surges in producer prices and wages point to further inflation in the pipeline, and no easy end in sight the BICEPS report authors referred to above conclude that we face the possibility "that the Latvian economy has shifted from a position of simple overheating to something more serious in structural terms".
Monetary Policy
Nowhere are the difficulties facing the Latvian authorities better illustrated than in the field of monetary policy. The Bank of Latvia has been steadily raising the refinancing rate, especially after it became apparent that Latvian economy was continuing to grow very rapidly, and that part, at least, of the reason for this was the boom in bank lending,. The rate was raised to 4.5% in July 2006 and to 5% last November. As of May 2007 the rate is 6%. At the same time the ECB has also been lifting its refinancing rate, from 2.25% to 3.5% in 2006, to the current (June 2007) rate of 4%, and this level now appears to be not too far from the peak. What this effectively means is that there will not be too much further room for increases from the BoL without taking the risk of precipitating substantial speculative inward capital flows, and in the process putting upward pressure on the euro peg (an indication of how this might work can be found in the fact that in the week of 18 June 2007 the Bank of Latvia found itself forced to intervene and sell Lat to buy Euros (28 million euro worth in that week) to try and take some of the upward pressure of the peg. This process has effectively been taking place off and on all year).
Of course, since Latvia's new inflation targets now lie well above the ECB criteria for some time to come (see the chart below, which comes from the Ministry of Finance summary of the anti-inflation package), the close alignment with the euro could be considered to be unnecessary at this point, and indeed a substantial devaluation in the currency might be thought to be a more palatable alternative to a hefty dose of deflation, were such a devaluation possible.
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Now I say were such a devaluation to be possible, since it isn't exactly clear whether, as long as the EU institutional structure and the ECB maintain their effective underwrite guarantee of Latvian solvency, the funds inflows which followed any loosening of the peg (or even hint of its possibility) might not well have the counter-productive effect of pushing the Lat even higher. In this situation what would effectively result would be a battle of wills between EU institutions and the international financial community, and I imagine that everyone (at least at this point) would rather avoid this eventuality.
Given the clear difficulties which the Latvian government face in using currency and interest rate measures many observers have reached the conclusion that, at the end of the day, the only measures which are now available to the them effectively boil down to fiscal ones. What this implies is that the Government's inflation plan can only generate a larger or smaller contraction of domestic demand depending on the severity of the fiscal contraction introduced. This whole position was more or less explicitly accepted by the IMF staff team who visited Latvia in April 2007 (see full reference below):
"Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2.25 percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax."
So what the IMF are effectively recommending is a budget surplus of between 2.25% and 4% of GDP. This is pretty hefty, but, even if it were to be implemented, would it be enough? This I think is very hard to say at this stage, but there are reasons for thinking it may well not be, in particular given the strength of consumer demand for credit from external sources (to give some idea of the strength of this, it may be worth noting that M2 was increasing at an annual rate of around 38.5% in 2006). At the same time if it is sufficient to give the shock which is evidently required, is there not the danger at the other extreme of overshoot, and that the impact of administering this non-lethal dose might still render the patient unconscious semi-permanently?
I ask the "would it be enough" question in a somewhat obtuse way above, since it is apparent that the Latvian government, which is hardly keen on inducing large scale unpopularity for itself by curtailing the perceived benefits of a booming economy by using deflation to - even temporarily - sharply lower living standards, remains reluctant to tighten fiscal policy in the way the IMF recommends. This I think would be the key point to note about the "anti-inflation" programme mentioned above. For the time being they are content to settle for a neutral balance budget, and this almost certainly will not be enough to quench the fire.
Thus it is not clear at this stage what institutional architecture there is in place to constrain any Latvian government at this point. Certainly the IMF itself no longer carries any real clout, and the EU Commission may also have cut Latvia adrift in a way they never intended when they pushed back over the horizon Latvia's euro membership (and here). Devil-may-care heterodox policies it seems are not only possible in Brazil and Thailand these days.
Government Spending and the Consumer Boom
An examination of the following chart may well help us put things in perspective insofar as the ability of a fiscal surplus of the magnitude being recommended by the IMF to achieve it's intended result.
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As can be seen government expenditure was running at something just under 900 million Lats per quarter in 2006, while GDP was running at something just over 2000 million Lats per quarter, which gives us a figure of around 45% of GDP for government spending. As such a 4% GDP surplus is large, since it amounts to either a tax increase of 8 to 10% of total revenue, or a reduction in spending of an equivalent order, or a combination of the two. This constitutes a relatively large shock to the economy. In addition, in the short term continuing producer price inflation will reduce exports, which constituted 48.1% of GDP in 2006 (so Lavia is relatively open and exposed in this sense) and this can also be expected to slow growth. In the opposite corner, and pushing the other way as it were, we have the future path of remittance flows and bank lending.
Taking remittances first, the World Bank Development Group estimates that remittances into Latvia were flowing at an annual rate of 381 million US dollars in 2005 (or 2.4% of GDP, see table below), but as they note the real numbers are likely to be significantly larger, and looking at growth across 2003-2005 the 2006 and 2007 numbers are most likely up (an estimate of a share of between 4% and 5% of GDP seems not unreasonable).
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So this push will continue, and indeed it is even not unreasonable to imagine that if "bursting" the overheating starts to have serious consequences in terms of distress at the individual level in Latvia, then we may well see more money coming in to try and help out family members.
On bank flows, bank’ borrowing from abroad remains by far the largest source of foreign financing for Latvia. If we look the current account deficit we will see it has been growing rapidly (see chart below, data 2004and Q1 2005 through Q3 2006).
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By Q3 2006 it was running at a negative rate of 1,269 US$ million, but as can be seen this is effectively covered by other items in the capital and financial account. During the first three quarters of 2006, “for example, other investment” (which is predominantly bank borrowing) arriving in Latvia came to US$3.3bn, which was some US$560m more than the entire current-account deficit for the period.
Evidently such foreign borrowing by Latvian banks ’has increased the external debt position substantially, and at the end June 2006, Latvia'’s net international investment position was some US$11.1bn in deficit, a quantity equivalent to around 80% of nominal GDP. Obviously an inward funds flow running at this level puts a significant cap on the ability of the fiscal measures to achieve their desired effect, and hence the emphasis from the IMF on institutional measures to get the levels of bank lending under control. According to the Bank of Latvia "parent banks of Latvian major commercial banks in Scandinavia have expressed their readiness to reduce the lending growth gradually", however, in Q1 2007 "net loans to Latvian banks reached 23.9% of GDP, a 4.2 percentage point increase over the average of 2006". Well, as they say, it is early days yet.
One of the implications of the structural diagnosis that is being offered (both here, and at the IMF, and by the BICEPS authors) is that implementing the anti-inflation plan will not allow Latvia to simultaneously achieve acceptable inflation, acceptable growth and a positive external balance. It would appear that Latvia has become strapped on the horns of a what is called in the literature a Tinbergen policy dilemma, simply put, and with or without the existing peg to the euro, it simply has too few instruments available with which to achieve its policy targets. (A classic explanation of the Tinbergen dilemma from none other than euro-intellectual father Robert A Mundell - I don't know whether to laugh or to cry at this point - can be found here, while another, and now rather outdated, version of the underlying idea - and one which became pretty fashionable in economic circles in the 1990s - is Krugman's eternal triangle. Obviously in the light of recent developments in the global financial and migration systems this whole literature is now badly in need of an update).
Interestingly - and again according to the BICEPS authors - the latest surge in inflation can neither be blamed on a low initial price base, on EU accession, or on unfavourable exchange rate developments, but is rather the direct result of overheating in the labour market coupled with an ongoing cycle of ever-higher inflation expectations. What the expectations problem means in the present context is that Latvia has become a country with very high (and rising) continuing inflation and Lavia's citizens are now fully aware of this and factor-it-in to wage demands, which in turn add to the production costs of firms and end up in higher prices, which of course then fuel higher wage demands. This is the classic wage-price spiral.
The East-West Wages Gap
Latvia's employment continues to rise, and unemployment remains on a downward path. Employment has been boosted by strong economic growth, and in the third quarter of 2006 the number of people employed reached 1,118,800, up by 7.2% compared with the same period a year before. Employment growth has accelerated, from 4.2% in the second quarter, and currently almost 62% of Latvians between the ages of 15 and 74 are employed"the highest level of employment since 1991. Conversely, the unemployment rate has continued to fall. In the third quarter of 2006 the unemployment rate"calculated according to International Labour Organisation (ILO) methodology"was 6.2%, down from 8.7% in the same period of 2005. Labour shortages are most acute in the capital, Riga, where registered unemployment is below 4%.
In the Latvian case there is one additional dilemma that is not current to the normal Tinbergen policy debate: the wage differential with say the UK or Ireland, and the problem of out-migration. The chart below, which compares the Irish and the Latvian wage distributions may be helpful in seeing the problem:
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Now this situation - namely that a period of restrained wage growth may produce yet more out-migration which in turn makes the domestic wage pressure even greater (another kind of 'vicious loop') - is by no means easy to address and as the October 2006 IMF staff report authors note:
Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration.
That is, one solution to the wage increase problem might be to open the frontiers to some extent to migrant labour, but policymakers worry that any resulting flow - being possibly mainly of unskilled workers - might only serve to push down unskilled wage rates and push more Latvian nationals over towards the UK and Ireland. Certainly the Economist Intelligence Unit in its most recent report also noted this issue (January 2007):
The government argues that rapid wage convergence with western Europe is needed to check emigration. On the latest estimate from the Bank of Latvia (BoL, the central bank), some 70,000 Latvians, or around 6% of the labour force, are currently working abroad, mostly in the UK and Ireland.
Of course there is no single clear remedy here, but I think we need to say strongly that this attempt to stem the migrant out-flow by being lax on the wage inflation front is to invite disaster, serious disaster.
Fertility, Migration and the Labour Supply
So the Latvian government is yet one more time here on the horns of a dilemma, and one this time which means they need to run, and keep running, in an ongoing chase to try and catch their own shadow. But how big is their demographic problem? Well to try and get some sort of appreciation we could think about the fact that during 2006 Latvian employment was increasing at an annual rate of around 70,000, while if we look at live births for a moment, we will see that since the early 1990s Latvia has been producing under 40,000 children annually (by 2006 this number is down to 21,000 (as the chart below makes clear).
Indeed ex-migrant flows, the Latvian population is now falling (by 0.648% annually according to the 2007 edition of the CIA World Factbook), and at a significant rate (the birth rate is at a very low level, 1.3TFR in 2006 according to the Population Reference Bureau). Taking into account uncertainties about out-migration (which is almost certainly greater then is reflected in the official statistics) in fact the rate of decline might be even greater.
At the same time the internal employment situation is becoming ever tighter, with unemployment levels becoming ever lower (see chart below, data 2005, and Q1 2005 through Q3 2006).
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As can be seen in Q3 2006, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2%. Put another way, an increase in employment of some 75,000 had produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn't take sophisticated mathematics - or "robust" models - to see that this cannot last.
One solution is obviously to try and increase the level of labour market participation, but - and it is interesting that almost no-one here seems to be talking about the need for labour market reforms - it is hard to estimate just how much potential in reality there still is for this. According to the Latvia Statistical Agency Q2 2006 labour force report:
In Q2 2006 more than a half (63.8%) of residents in the age from 15 to 74 were economically active – this indicator was 68.9% amongst males, and 59.4% amongst females. in the 2nd quarter of 2006, the number of economically active population, in comparison with the corresponding period of 2005, increased by 2%.
These numbers, since they include everyone up to 74, and many under 20 - an age where education may still be taking place in many cases - are really very hard to interpret. But whichever way you look at it there is certainly a problem, since wage increases of this order would normally be considered to motivate more labour to come into the market, were it available. However, before going into this labour market structural bind in greater depth, let's take a look at some more of the details of the general economic dilemma.
Producer Prices and Wages
The Producer Price Index measures changes in the price level of most of the manufactured goods produced in a country. The major difference for present purposes between the CPI and the PPI is that the latter excludes imported goods. The recent dramatic upward path which the PPI has followed can be seen in the following graph (Source Biceps report):
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In the Latvian case imported goods constitute an important component in CPI since imports account for over half of Latvia’s GDP. Now as we know, inflation in domestically produced goods is very high indeed - currently approaching 20% - while CPI inflation, even though it is now at the highest level for the last decade, is significantly lower due to the low inflation component for imported goods (which is naturally eased, of course, by the way the Lat has been tending to rise in tandem with the euro). The difference in trend for CPI and PPI can be seen in the figure below (source: Biceps report), and it is clear that PPI inflation has been surging much more dramatically than CPI inflation since January 2006.
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Now all of this presents rather a large problem when thought of in terms of the international competitiveness of the Latvian economy since a position where the price path of externally produced goods is considerably lower than the price path of Latvian produced goods is evidently not sustainable. And if, as seems reasonable to assume, inflation is being affected by higher expected inflation which workers factor-in to their wage demands, aided and abetted by a perceived tolerance from the Latvian authorities given the migration constraints mentioned above, then the key to all this is clearly the structural issue of the presence of a very tight labour market, and the constraint which this puts on capacity growth moving forward. The result is again very evident: a strong upward pressure on wages which can be seen in the following chart (Source Biceps report):
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As the BICEPS authors note, the high degree of similarity (correlation) in the movement of the two graphs (wages and PPI) is striking and suggests that wage growth "is passed on in the form of price increases with a time lag of around 15 months". Again as the BICEPS authors conclude:
"The implication is quite sinister: The current surge in wages has still not shown up fully in inflation but we should expect it to do so later i.e. PPI inflation is very likely to increase and with it to some extent CPI inflation, too. If this is believable, inflation will thus rise before the government’s antiinflation plan may kick in and dampen inflation......The recent surges in wage growth, PPI growth and CPI growth are also worrying in the sense that they seem to indicate a shift in the economy from simply overheated to potentially structurally imbalanced."
So a relatively simple analysis is all that is needed to see clearly that the Latvian inflation problem cannot be addressed separately from the current imbalances in the labour market. As the next section will demonstrate the inflation problem cannot be addressed separately from the imbalance in the external sector either.
Recent Latvian Current Account Deficits
Moving on now to the external position, many things might be said, but one thing is for sure: Latvia’s current account deficit at 21.3% of GDP in 2006 is not a sustainable position. Only 10 countries in the world had higher current account deficits in 2006 than Latvia, and most of these were small island economies with populations of less than 1m (and some of them even as low as 40 000). So it is clear that Latvia’s deficit has become excessive, even by EU8 standards (see chart below).
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Latvia in fact was running fairly high current-account deficits throughout the late 1990s (at an annual average of 6.8% of GDP in 1996-2000), but these were mainly financed by inflows of foreign direct investment (FDI) as Latvia steadily sold-off most of its state-owned assets. Since 2001, however, the burden of financing the deficit has moved increasingly towards borrowing (FDI covered 84% of the current-account deficit in 1996-2000, but just 30% in 2001-05), and Latvia's external debt has soared from just 22% of GDP in 1996 to an estimated 112% of GDP in 2006.
But what lies behind the recent substantial deterioration in the current account? The figure below shows developments in the real effective exchange rate (REER) in terms of producer prices against Latvia’s main trading partners:
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The key point to note here is the rapid and seemingly accelerating loss of competitiveness which has been taking place in Latvia since mid-2005. This loss of competitiveness is dramatically reflected in the most recent developments in export and import volumes as can be seen in the chart below.
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The disconnect that is being produced here is pretty clear even at a simple glance. What is not so clear are the mid term consequences of this evolution.
In the fourth quarter of 2006 the current-account deficit seems to have momentarily peaked at 26.3% of GDP, with the very high reading being mainly the result of a deterioration in the trade balance. According to the Bank of Latvia, the current account deficit in Q1 2007 was running at 25.7% of GDP (see chart below).
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Again, as the Bank of Latvia note:
"In the first quarter, total direct investment in Latvia grew by 7.3% year-on-year, covering one third of the current account deficit. The largest part of the current account deficit was financed by borrowing from foreign banks. Reserve assets increased by 45.5 million lats."
Internal Consumption and the Housing Dimension
As we are seeing the Latvian economy is currently expanding at a breathtaking rate, driven by a variety of mechanisms, including negative real interest rates, EU grants, and strong real wage increases. GDP growth averaged just under 12% during 2006, up from just over 10% in 2005. In particular the trend reflects the very rapid increase in household credit as well as sizable spending on EU-related projects and transfers (which nearly doubled to 3.25% of GDP in the first full year of EU membership in 2005). While external demand did contribute positively to growth in 2005, this was really a one-off, with the subsequent strengthening of imports and weakening of exports producing a negative net exports balance from early 2006 onwards.
Rapid financial deepening continues, and with it increasing bank exposures to credit and market risk. Credit to private sector residents grew nearly 65 percent in 2005, and the loan to GDP ratio reached 70 percent, triple the level in 2000, becoming in the process the highest in the EU8. New loans are disproportionately skewed towards household mortgages - which have almost doubled to constitute 20 percent of GDP (although this is still well below the EU15 average of 48 percent) - and such mortgages are increasingly denominated in euros. As a result, housing prices have grown sharply (at an annual rate of about 50 percent through mid-2006: see graph below) and are now at very high levels.
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At the end of September 2006 lending to households was up by 80% year on year. It is entirely possible that a housing price bubble has now developed, and one interesting comparison is that while in Estonia and Lithuania house prices did start to stabilise somewhat in late 2006, in Latvia they have continued to rise by about 2% a month. According to the Q1 2007 y-o-y Knight Frank Global House Index, Riga (Latvia's capital) was the global price increase champion, with a staggering 61.2% increase over Q1 2006.
So while the financial soundness indicators for the banking sector remain strong - there are for example very few nonperforming loans (NPLs) and high levels of profitability are being maintained - these measures are in-essence backward looking. With the real estate sector now accounting for around half of total loans, and direct and indirect euro exposure having risen sharply (reflecting both the lifting of limits on open euro positions following the repeg of the lats to the euro and the rapid expansion in euro-denominated loans to mostly-unhedged households) risks have obviously increased.
Migration As A Solution?
Well given that a strategy of relying exclusively on fiscal tightening and strong deflation is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints somewhat via an open-the-doors policy towards inward migration and with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.
However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these has already been mentioned: that this may ultimately put downward pressure on unskilled workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a “slightly positive” impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.
A further difficulty is the lack of availability of accurate data on the actual scale of either inward or outward migration in Latvia (this difficulty is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad - mostly in the UK and Ireland - but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).
Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latvia’s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either “very likely” or “somewhat likely” to go to another country for work “in the next two years”. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.
But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table below.
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Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.
In fact, if we look at the chart below, we will see that during 2003 the rate of out migration from Latvia seems to have dropped substantially, and given what we know about the post 2004 out migration boom, this, on the surface, seems strange.
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The answer to this puzzle is to do with the Russophone population who are not Latvian citizens (and therefore logically at this point not EU citizens either). The majority of the pre 2004 out-migration was actually towards the CIS, and it is reasonable to assume that many of these migrants came from the Russian speaking population. And this process is not over as this recent article from Itar-Tass about a joint project to settle Russian speaking Latvian residents in Kaliningrad makes clear.
So clearly the fact that the Latvian authorities may still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere gives an indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.
Yet one more time the difference with Estonia couldn't be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals - which before Parliament by November - which will attempt to address Estonia’s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start.
Towards A Policy Driven Exit
So what is the remedy? Well, lets look again at the IMF proposals:
a) Fiscal policy: Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2¼ percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax.
b) Credit and prudential policies: Sharply curtailing and improving the risk profile of new lending is essential to mitigating macroeconomic and financial stability risks. Rebalancing incentives governing credit growth is therefore essential. The mission supports the effective implementation of the credit-restraining measures in the anti-inflation plan, including fully documenting legal income to secure a loan, establishing a comprehensive register of all loans, and requiring a 10 percent minimum downpayment. We also welcome the recent reimposition of limits on banks' open positions in euros. Additional regulatory measures are also needed to slow credit growth and induce banks to internalize systemic risk in real estate and currency markets. The FCMC, working with the Bank of Latvia, should increase its emphasis on monitoring systemic risk through more frequent on-site inspections of large banks and ensuring that foreign banks tailor their credit-risk models to the Latvian context.
c) Real estate policies: Rebalancing the structure of the economy away from the nontradables sector, especially real estate, is essential to underpin needed current account adjustment. The mission welcomes the increase in real estate taxation envisaged in the anti-inflation plan, as well as the periodic reassessment of cadastral values, beginning in 2007. To be effective, however, enforcement of real-estate related taxation should be stepped up. To further relieve overheating in the construction sector, it will be necessary to significantly scale back government capital expenditure (planned at 5 percent of GDP for 2007)."
d) Labor market policies: Efficient labor utilization is critical to expand aggregate supply and contain surging wage costs, which are contributing to overheating and undermining Latvia's competitiveness. The greater flexibility allowed in the use of fixed-term employment contracts introduced in the 2006 Amendment to the Labor Law is welcome, and further steps to facilitate mobility between jobs and regions are needed. The recent decision to allow unfettered labor market access to the newest EU members may help relieve bottlenecks, and wider temporary access should also be considered.
The above IMF package is clearly a big move in the right direction. My principal worry is that the severity of the shock produced may have a significant longer term impact in a negative direction than is desirable, especially if the package is followed by a bursting of the housing bubble which could in itself precipatate yet another outward stream of migrants. However, as we have seen above, the Latvian government is itself far from accepting the need for the totality of the package, and in particular as regards the fiscal dimension. But I think the big missing issue which is not being addressed here is the labour supply one. A systematic move to apply the fiscal braek, to tighten lending conditions and to facilitate an increased supply of labour would seem to offer a better possibility of bringing about the necessary correction without completely upsetting the apple cart in the process, so I therefore think that such labour supply measures should now be considered as a matter of urgency.
Hard landing?
Of course debating the niceties of the policies we would like to see is one thing, and addressing the economic realities of the policies we have is another. If domestic demand does not abate steadily now, a hard landing could well result. Under this kind of scenario, one or two more years of GDP growth in excess of an annual 10% rate would probably lead to such pressure on the labour market (remember the unemployment rate was dropping in 2006 by about 2.5% a year) and thus to such an acceleration in inflation that the impact on competitiveness and external liabilities would become unbearable. Under these circumstances attracting the necessary external financing would become increasingly difficult, and a sharp slowdown would probably result as the underlying accumulated output gap was corrected in an unduly short space of time. The most worrying point about such a scenario is that we really don't know the long term consequences it might induce. Latvia - like many East European and Central Asian societies is about to experience a severe demographic challenge, and it would be better to face that challenge with the wind behind you rather than the wind in your face, and certainly better to try and chart your own course than head off in the direction of "destination unknown".
References
Inflation in Latvia: Causes, Prospects and Consequences, by Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics.
Statement by IMF Mission to Latvia on 2007 Article IV Consultation Discussions, May 2007.
Republic of Latvia: 2006 Article IV Consultation - Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Latvia, October 2006
Republic of Latvia: Selected Issues, IMF October 2006
Language Use and Intercultural Communication in Latvia
Inese Ozolina
"Changes of Ethnic Structure and Characteristics of Minorities in Latvia"
by Peteris Zvidrins
'Exit' in deeply divided societies : regimes of discrimination in Estonia and Latvia and the potential for Russophone migration. Hughes, James (2005) Journal of common market studies, 43 (4). pp. 739-762. ISSN 1747-5244
Estonian Report on Russian Minority
Aksel Kirch
Latvian Naturalization Board, Statistical Information on Acquisition of the Citizenship of Latvia as at May 31, 2007.
"Latvia, like other recent EU entrants, has benefited from an accession-related boost to income convergence....."Recently, however, fast credit and wage growth has caused the economy to diverge from a balanced and sustainable growth path, with domestic demand outstripping Latvia's supply capacity. As a result, overheating has intensified, bringing higher price and wage inflation, a sharply wider current account deficit, and greater external indebtedness. Rapid credit growth in euros has left large currency mismatches on the balance sheets of households and corporates and a boom in housing prices that has diverted resources from the tradable sector. A pervasive "buy now-pay later" mindset has settled in and is heightening systemic risk. These developments, if not tackled firmly, will thwart a recovery of export growth."
"There is an urgent need for decisive action to unwind overheating pressures and narrow external imbalances by sharply curtailing domestic demand. Notwithstanding actions by the Bank of Latvia to raise risk awareness, recent pressure on the lats signals growing investor impatience with the limited policy response so far. A comprehensive strategy is therefore needed to curb domestic spending and wage growth, and moderate real estate prices to rebalance incentives for investing in tradables sectors."
What now follows is a long (very long, even by my recent standards) post which examines the core features of Latvia's current economic malaise. It is generally recognised by most external observers that this malaise has its origins in structural problems in the Latvian labour market, and it will be argued here that these structural problems have their roots in recent characteristics of Latvian demography (namely high out-migration and a sustained low birth rate). As such there is no easy solution. Even in the longer run the position will inevitably be difficult, since demography almost inevitably casts a long shadow. This does not mean, however, that we should be complacent. There are steps which can be taken to address the issues which Latvia faces in the short term, and it is important that such appropriate measures are enacted. These measures clearly include policies to reduce the dramatic overheating which is taking place, but they also should include policies to loosen the labour supply, not only by encouraging increased labour market participation and mobility, but also by actively encourage inward migration. Such policies may be seen as short term measures which are vital to move Latvia away from an unsustainable and towards a sustainable economic path.
The Measure of the Problem
As I have said, and previously noted in this post, according to the latest Eurostat data, wages and salaries in Latvia rose in Q1 (as compared with a year earlier) by an astonishing 32.7%. This rate of increase is, in and of itself a symptom of something important, and is clearly unsustainable.
For a simple coverage of recent developments this recent Bloomberg article gives a useful summary of the underlying dynamic involved.
According to Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics (in this BICEPS report) "Latvia's inflation, the fastest in the European Union, will continue to erode the competitiveness of the country's' exports as it shows no sign of slowing"
In fact Latvia's inflation rate (CPI, see Graph below) reached a 10-year high of 8.9 percent in April 2007, largely driven by growth in wages and producer-prices.
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As a consequence of this wage and price growth the competitiveness of Latvia's exporters has been so eroded, and the trade balance so negatively affected (see graph below), that the economy is now destined either to go through a very long period of deflation, or to undergo a substantial devaluation of the currency in order to put the ship back on an even keel. But if the Latvian government were to opt for the latter course we would hit a problem, since the traditional route for correcting such a deficit - letting a currency freely float (the Lats has been loosely pegged* to the Euro since early 2005) and raising interest rates - is not so obviously open here. In today's perverse world of global liquidity and international capital flows it could well be that any increase in central bank interest rates would simply suck-in even more funds in a steady and ongoing search for yield. Appetite for risk might not be reduced by the appearance of non-sustainability since - and this would be the big initial difference from say Turkey in 2006 - the EU and the ECB are ultimately seen as guarantors of the last resort for the Latvian economy. So effectively the situation could turn into a battle of wills between speculators looking for yield and the EU institutional structure.
( *The Latvian currency, the Lats, is allowed to move by plus or minus 1 percent around a midpoint against the euro. The lats is currently worth somewhere around 1.43 euro).
As can be seen from the graph below, Latvia's current-account deficit has more than doubled over the last two years, and the quarterly current-account deficit, for example, grew from around 10% of GDP in Q1 2005 to 26% of GDP in Q1 2006.
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Thus Latvia now has the somewhat dubious merit of having the fastest growing economy, the highest inflation, and largest current-account deficit in the 27-nation EU. Since the country has a fixed exchange rate (which could be made more flexible, although, as we will, doing this in itself raises as many problems as it could solve, since the currency could just as easily be lead to float up as down), and raising interest rates may well only draw even more liquidity into an economy where the majority of consumer credit expansion is now in non-Lats denominated loans (70% of domestic credit is now denominated in euros), the Latvian government is really only left with fiscal policy as the major instrument with which to try to correct the growing internal and external imbalances.
As Lars Christensen, senior economist at A/S Danske Bank (who is quoted by Bloomberg) says: "Money supply and credit growth have created a property bubble. What has fueled growth and credit has been cheap liquidity, globally rather than locally."
An Anti Inflation Programme?
So what do we have here? Well, despite considerable talk and concern, the inflation problem in Latvia has not gone away in recent months, if anything has intensified. The Latvian government do seem to be as concerned as anyone, and on the back of the problem have set up a working group on inflation, which published its current anti-inflation plan in March, and which, according to the Bank of Lavia, "continues to monitor the situation". Despite strong prodding from the IMF, the aims of Latvian government policy as contained in the report - and summarized by the Finance Ministry here - are surprisingly modest given the severity of the situation, namely:
i) to maintain a balanced budget (ie, neither deficit nor surplus) for 2007, and attempt to attain a surplus by 2009/10.
ii) to impose a real estate tax on properties sold which have been owned for less than 3 years;
iii) to attempt to make it more difficult to obtain credit by, for example, requiring commercial banks and leasing companies to better determine the purchasing power of customers and to make loans available exclusively on the legal income of clients;
iv) to exercise better control over energy prices
v) to introduce measures aimed at increasing labour market participation and increasing productivity, as well as product-market-competition reforms. As the summary says, these last items are by their very nature long term, and as such hardly appear to form a core part of the "crisis" short term package.
All in all then, an extraordinarily relaxed programme it would seem under the circumstances.
Now (as indicated above) both wages (32.8% growth y-o-y in Q1 2007) and producer prices (16% - 18% growth y-o-y in early 2007) have been accelerating recently with wage growth being estimated to feed into producer prices with a lag of approximately 15 months. This increase in producer prices in turn then feeds into export prices, and the consequence is a continuing and sustained loss of international competitiveness.
Now the existence of this evident feed through between wages and producer prices means that there is now a wide consensus (both inside Latvia itself and among international observers) that the inflation problem cannot be addressed separately from the imbalances which exist in Latvia's internal labour market (imbalances to which outward migration in the early years of this century and many years of below replacement fertility - see below - have contributed in no small way). Since the recent surges in producer prices and wages point to further inflation in the pipeline, and no easy end in sight the BICEPS report authors referred to above conclude that we face the possibility "that the Latvian economy has shifted from a position of simple overheating to something more serious in structural terms".
Monetary Policy
Nowhere are the difficulties facing the Latvian authorities better illustrated than in the field of monetary policy. The Bank of Latvia has been steadily raising the refinancing rate, especially after it became apparent that Latvian economy was continuing to grow very rapidly, and that part, at least, of the reason for this was the boom in bank lending,. The rate was raised to 4.5% in July 2006 and to 5% last November. As of May 2007 the rate is 6%. At the same time the ECB has also been lifting its refinancing rate, from 2.25% to 3.5% in 2006, to the current (June 2007) rate of 4%, and this level now appears to be not too far from the peak. What this effectively means is that there will not be too much further room for increases from the BoL without taking the risk of precipitating substantial speculative inward capital flows, and in the process putting upward pressure on the euro peg (an indication of how this might work can be found in the fact that in the week of 18 June 2007 the Bank of Latvia found itself forced to intervene and sell Lat to buy Euros (28 million euro worth in that week) to try and take some of the upward pressure of the peg. This process has effectively been taking place off and on all year).
Of course, since Latvia's new inflation targets now lie well above the ECB criteria for some time to come (see the chart below, which comes from the Ministry of Finance summary of the anti-inflation package), the close alignment with the euro could be considered to be unnecessary at this point, and indeed a substantial devaluation in the currency might be thought to be a more palatable alternative to a hefty dose of deflation, were such a devaluation possible.
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Now I say were such a devaluation to be possible, since it isn't exactly clear whether, as long as the EU institutional structure and the ECB maintain their effective underwrite guarantee of Latvian solvency, the funds inflows which followed any loosening of the peg (or even hint of its possibility) might not well have the counter-productive effect of pushing the Lat even higher. In this situation what would effectively result would be a battle of wills between EU institutions and the international financial community, and I imagine that everyone (at least at this point) would rather avoid this eventuality.Given the clear difficulties which the Latvian government face in using currency and interest rate measures many observers have reached the conclusion that, at the end of the day, the only measures which are now available to the them effectively boil down to fiscal ones. What this implies is that the Government's inflation plan can only generate a larger or smaller contraction of domestic demand depending on the severity of the fiscal contraction introduced. This whole position was more or less explicitly accepted by the IMF staff team who visited Latvia in April 2007 (see full reference below):
"Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2.25 percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax."
So what the IMF are effectively recommending is a budget surplus of between 2.25% and 4% of GDP. This is pretty hefty, but, even if it were to be implemented, would it be enough? This I think is very hard to say at this stage, but there are reasons for thinking it may well not be, in particular given the strength of consumer demand for credit from external sources (to give some idea of the strength of this, it may be worth noting that M2 was increasing at an annual rate of around 38.5% in 2006). At the same time if it is sufficient to give the shock which is evidently required, is there not the danger at the other extreme of overshoot, and that the impact of administering this non-lethal dose might still render the patient unconscious semi-permanently?
I ask the "would it be enough" question in a somewhat obtuse way above, since it is apparent that the Latvian government, which is hardly keen on inducing large scale unpopularity for itself by curtailing the perceived benefits of a booming economy by using deflation to - even temporarily - sharply lower living standards, remains reluctant to tighten fiscal policy in the way the IMF recommends. This I think would be the key point to note about the "anti-inflation" programme mentioned above. For the time being they are content to settle for a neutral balance budget, and this almost certainly will not be enough to quench the fire.
Thus it is not clear at this stage what institutional architecture there is in place to constrain any Latvian government at this point. Certainly the IMF itself no longer carries any real clout, and the EU Commission may also have cut Latvia adrift in a way they never intended when they pushed back over the horizon Latvia's euro membership (and here). Devil-may-care heterodox policies it seems are not only possible in Brazil and Thailand these days.
Government Spending and the Consumer Boom
An examination of the following chart may well help us put things in perspective insofar as the ability of a fiscal surplus of the magnitude being recommended by the IMF to achieve it's intended result.
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As can be seen government expenditure was running at something just under 900 million Lats per quarter in 2006, while GDP was running at something just over 2000 million Lats per quarter, which gives us a figure of around 45% of GDP for government spending. As such a 4% GDP surplus is large, since it amounts to either a tax increase of 8 to 10% of total revenue, or a reduction in spending of an equivalent order, or a combination of the two. This constitutes a relatively large shock to the economy. In addition, in the short term continuing producer price inflation will reduce exports, which constituted 48.1% of GDP in 2006 (so Lavia is relatively open and exposed in this sense) and this can also be expected to slow growth. In the opposite corner, and pushing the other way as it were, we have the future path of remittance flows and bank lending.
Taking remittances first, the World Bank Development Group estimates that remittances into Latvia were flowing at an annual rate of 381 million US dollars in 2005 (or 2.4% of GDP, see table below), but as they note the real numbers are likely to be significantly larger, and looking at growth across 2003-2005 the 2006 and 2007 numbers are most likely up (an estimate of a share of between 4% and 5% of GDP seems not unreasonable).
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So this push will continue, and indeed it is even not unreasonable to imagine that if "bursting" the overheating starts to have serious consequences in terms of distress at the individual level in Latvia, then we may well see more money coming in to try and help out family members.On bank flows, bank’ borrowing from abroad remains by far the largest source of foreign financing for Latvia. If we look the current account deficit we will see it has been growing rapidly (see chart below, data 2004and Q1 2005 through Q3 2006).
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By Q3 2006 it was running at a negative rate of 1,269 US$ million, but as can be seen this is effectively covered by other items in the capital and financial account. During the first three quarters of 2006, “for example, other investment” (which is predominantly bank borrowing) arriving in Latvia came to US$3.3bn, which was some US$560m more than the entire current-account deficit for the period.
Evidently such foreign borrowing by Latvian banks ’has increased the external debt position substantially, and at the end June 2006, Latvia'’s net international investment position was some US$11.1bn in deficit, a quantity equivalent to around 80% of nominal GDP. Obviously an inward funds flow running at this level puts a significant cap on the ability of the fiscal measures to achieve their desired effect, and hence the emphasis from the IMF on institutional measures to get the levels of bank lending under control. According to the Bank of Latvia "parent banks of Latvian major commercial banks in Scandinavia have expressed their readiness to reduce the lending growth gradually", however, in Q1 2007 "net loans to Latvian banks reached 23.9% of GDP, a 4.2 percentage point increase over the average of 2006". Well, as they say, it is early days yet.
One of the implications of the structural diagnosis that is being offered (both here, and at the IMF, and by the BICEPS authors) is that implementing the anti-inflation plan will not allow Latvia to simultaneously achieve acceptable inflation, acceptable growth and a positive external balance. It would appear that Latvia has become strapped on the horns of a what is called in the literature a Tinbergen policy dilemma, simply put, and with or without the existing peg to the euro, it simply has too few instruments available with which to achieve its policy targets. (A classic explanation of the Tinbergen dilemma from none other than euro-intellectual father Robert A Mundell - I don't know whether to laugh or to cry at this point - can be found here, while another, and now rather outdated, version of the underlying idea - and one which became pretty fashionable in economic circles in the 1990s - is Krugman's eternal triangle. Obviously in the light of recent developments in the global financial and migration systems this whole literature is now badly in need of an update).
Interestingly - and again according to the BICEPS authors - the latest surge in inflation can neither be blamed on a low initial price base, on EU accession, or on unfavourable exchange rate developments, but is rather the direct result of overheating in the labour market coupled with an ongoing cycle of ever-higher inflation expectations. What the expectations problem means in the present context is that Latvia has become a country with very high (and rising) continuing inflation and Lavia's citizens are now fully aware of this and factor-it-in to wage demands, which in turn add to the production costs of firms and end up in higher prices, which of course then fuel higher wage demands. This is the classic wage-price spiral.
The East-West Wages Gap
Latvia's employment continues to rise, and unemployment remains on a downward path. Employment has been boosted by strong economic growth, and in the third quarter of 2006 the number of people employed reached 1,118,800, up by 7.2% compared with the same period a year before. Employment growth has accelerated, from 4.2% in the second quarter, and currently almost 62% of Latvians between the ages of 15 and 74 are employed"the highest level of employment since 1991. Conversely, the unemployment rate has continued to fall. In the third quarter of 2006 the unemployment rate"calculated according to International Labour Organisation (ILO) methodology"was 6.2%, down from 8.7% in the same period of 2005. Labour shortages are most acute in the capital, Riga, where registered unemployment is below 4%.
In the Latvian case there is one additional dilemma that is not current to the normal Tinbergen policy debate: the wage differential with say the UK or Ireland, and the problem of out-migration. The chart below, which compares the Irish and the Latvian wage distributions may be helpful in seeing the problem:
(please click over image for better viewing)
Now this situation - namely that a period of restrained wage growth may produce yet more out-migration which in turn makes the domestic wage pressure even greater (another kind of 'vicious loop') - is by no means easy to address and as the October 2006 IMF staff report authors note:
Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration.
That is, one solution to the wage increase problem might be to open the frontiers to some extent to migrant labour, but policymakers worry that any resulting flow - being possibly mainly of unskilled workers - might only serve to push down unskilled wage rates and push more Latvian nationals over towards the UK and Ireland. Certainly the Economist Intelligence Unit in its most recent report also noted this issue (January 2007):
The government argues that rapid wage convergence with western Europe is needed to check emigration. On the latest estimate from the Bank of Latvia (BoL, the central bank), some 70,000 Latvians, or around 6% of the labour force, are currently working abroad, mostly in the UK and Ireland.
Of course there is no single clear remedy here, but I think we need to say strongly that this attempt to stem the migrant out-flow by being lax on the wage inflation front is to invite disaster, serious disaster.
Fertility, Migration and the Labour Supply
So the Latvian government is yet one more time here on the horns of a dilemma, and one this time which means they need to run, and keep running, in an ongoing chase to try and catch their own shadow. But how big is their demographic problem? Well to try and get some sort of appreciation we could think about the fact that during 2006 Latvian employment was increasing at an annual rate of around 70,000, while if we look at live births for a moment, we will see that since the early 1990s Latvia has been producing under 40,000 children annually (by 2006 this number is down to 21,000 (as the chart below makes clear).
Indeed ex-migrant flows, the Latvian population is now falling (by 0.648% annually according to the 2007 edition of the CIA World Factbook), and at a significant rate (the birth rate is at a very low level, 1.3TFR in 2006 according to the Population Reference Bureau). Taking into account uncertainties about out-migration (which is almost certainly greater then is reflected in the official statistics) in fact the rate of decline might be even greater.
At the same time the internal employment situation is becoming ever tighter, with unemployment levels becoming ever lower (see chart below, data 2005, and Q1 2005 through Q3 2006).
(please click over image for better viewing)
As can be seen in Q3 2006, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2%. Put another way, an increase in employment of some 75,000 had produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn't take sophisticated mathematics - or "robust" models - to see that this cannot last.
One solution is obviously to try and increase the level of labour market participation, but - and it is interesting that almost no-one here seems to be talking about the need for labour market reforms - it is hard to estimate just how much potential in reality there still is for this. According to the Latvia Statistical Agency Q2 2006 labour force report:
In Q2 2006 more than a half (63.8%) of residents in the age from 15 to 74 were economically active – this indicator was 68.9% amongst males, and 59.4% amongst females. in the 2nd quarter of 2006, the number of economically active population, in comparison with the corresponding period of 2005, increased by 2%.
These numbers, since they include everyone up to 74, and many under 20 - an age where education may still be taking place in many cases - are really very hard to interpret. But whichever way you look at it there is certainly a problem, since wage increases of this order would normally be considered to motivate more labour to come into the market, were it available. However, before going into this labour market structural bind in greater depth, let's take a look at some more of the details of the general economic dilemma.
Producer Prices and Wages
The Producer Price Index measures changes in the price level of most of the manufactured goods produced in a country. The major difference for present purposes between the CPI and the PPI is that the latter excludes imported goods. The recent dramatic upward path which the PPI has followed can be seen in the following graph (Source Biceps report):
(please click over image for better viewing)
In the Latvian case imported goods constitute an important component in CPI since imports account for over half of Latvia’s GDP. Now as we know, inflation in domestically produced goods is very high indeed - currently approaching 20% - while CPI inflation, even though it is now at the highest level for the last decade, is significantly lower due to the low inflation component for imported goods (which is naturally eased, of course, by the way the Lat has been tending to rise in tandem with the euro). The difference in trend for CPI and PPI can be seen in the figure below (source: Biceps report), and it is clear that PPI inflation has been surging much more dramatically than CPI inflation since January 2006.(please click over image for better viewing)
Now all of this presents rather a large problem when thought of in terms of the international competitiveness of the Latvian economy since a position where the price path of externally produced goods is considerably lower than the price path of Latvian produced goods is evidently not sustainable. And if, as seems reasonable to assume, inflation is being affected by higher expected inflation which workers factor-in to their wage demands, aided and abetted by a perceived tolerance from the Latvian authorities given the migration constraints mentioned above, then the key to all this is clearly the structural issue of the presence of a very tight labour market, and the constraint which this puts on capacity growth moving forward. The result is again very evident: a strong upward pressure on wages which can be seen in the following chart (Source Biceps report):
(please click over image for better viewing)
As the BICEPS authors note, the high degree of similarity (correlation) in the movement of the two graphs (wages and PPI) is striking and suggests that wage growth "is passed on in the form of price increases with a time lag of around 15 months". Again as the BICEPS authors conclude:
"The implication is quite sinister: The current surge in wages has still not shown up fully in inflation but we should expect it to do so later i.e. PPI inflation is very likely to increase and with it to some extent CPI inflation, too. If this is believable, inflation will thus rise before the government’s antiinflation plan may kick in and dampen inflation......The recent surges in wage growth, PPI growth and CPI growth are also worrying in the sense that they seem to indicate a shift in the economy from simply overheated to potentially structurally imbalanced."
So a relatively simple analysis is all that is needed to see clearly that the Latvian inflation problem cannot be addressed separately from the current imbalances in the labour market. As the next section will demonstrate the inflation problem cannot be addressed separately from the imbalance in the external sector either.
Recent Latvian Current Account Deficits
Moving on now to the external position, many things might be said, but one thing is for sure: Latvia’s current account deficit at 21.3% of GDP in 2006 is not a sustainable position. Only 10 countries in the world had higher current account deficits in 2006 than Latvia, and most of these were small island economies with populations of less than 1m (and some of them even as low as 40 000). So it is clear that Latvia’s deficit has become excessive, even by EU8 standards (see chart below).
(please click over image for better viewing)
Latvia in fact was running fairly high current-account deficits throughout the late 1990s (at an annual average of 6.8% of GDP in 1996-2000), but these were mainly financed by inflows of foreign direct investment (FDI) as Latvia steadily sold-off most of its state-owned assets. Since 2001, however, the burden of financing the deficit has moved increasingly towards borrowing (FDI covered 84% of the current-account deficit in 1996-2000, but just 30% in 2001-05), and Latvia's external debt has soared from just 22% of GDP in 1996 to an estimated 112% of GDP in 2006.
But what lies behind the recent substantial deterioration in the current account? The figure below shows developments in the real effective exchange rate (REER) in terms of producer prices against Latvia’s main trading partners:
(please click over image for better viewing)
The key point to note here is the rapid and seemingly accelerating loss of competitiveness which has been taking place in Latvia since mid-2005. This loss of competitiveness is dramatically reflected in the most recent developments in export and import volumes as can be seen in the chart below.
(please click over image for better viewing)
The disconnect that is being produced here is pretty clear even at a simple glance. What is not so clear are the mid term consequences of this evolution.
In the fourth quarter of 2006 the current-account deficit seems to have momentarily peaked at 26.3% of GDP, with the very high reading being mainly the result of a deterioration in the trade balance. According to the Bank of Latvia, the current account deficit in Q1 2007 was running at 25.7% of GDP (see chart below).
(please click over image for better viewing)
Again, as the Bank of Latvia note:"In the first quarter, total direct investment in Latvia grew by 7.3% year-on-year, covering one third of the current account deficit. The largest part of the current account deficit was financed by borrowing from foreign banks. Reserve assets increased by 45.5 million lats."
Internal Consumption and the Housing Dimension
As we are seeing the Latvian economy is currently expanding at a breathtaking rate, driven by a variety of mechanisms, including negative real interest rates, EU grants, and strong real wage increases. GDP growth averaged just under 12% during 2006, up from just over 10% in 2005. In particular the trend reflects the very rapid increase in household credit as well as sizable spending on EU-related projects and transfers (which nearly doubled to 3.25% of GDP in the first full year of EU membership in 2005). While external demand did contribute positively to growth in 2005, this was really a one-off, with the subsequent strengthening of imports and weakening of exports producing a negative net exports balance from early 2006 onwards.
Rapid financial deepening continues, and with it increasing bank exposures to credit and market risk. Credit to private sector residents grew nearly 65 percent in 2005, and the loan to GDP ratio reached 70 percent, triple the level in 2000, becoming in the process the highest in the EU8. New loans are disproportionately skewed towards household mortgages - which have almost doubled to constitute 20 percent of GDP (although this is still well below the EU15 average of 48 percent) - and such mortgages are increasingly denominated in euros. As a result, housing prices have grown sharply (at an annual rate of about 50 percent through mid-2006: see graph below) and are now at very high levels.
(please click over image for better viewing)
At the end of September 2006 lending to households was up by 80% year on year. It is entirely possible that a housing price bubble has now developed, and one interesting comparison is that while in Estonia and Lithuania house prices did start to stabilise somewhat in late 2006, in Latvia they have continued to rise by about 2% a month. According to the Q1 2007 y-o-y Knight Frank Global House Index, Riga (Latvia's capital) was the global price increase champion, with a staggering 61.2% increase over Q1 2006.
So while the financial soundness indicators for the banking sector remain strong - there are for example very few nonperforming loans (NPLs) and high levels of profitability are being maintained - these measures are in-essence backward looking. With the real estate sector now accounting for around half of total loans, and direct and indirect euro exposure having risen sharply (reflecting both the lifting of limits on open euro positions following the repeg of the lats to the euro and the rapid expansion in euro-denominated loans to mostly-unhedged households) risks have obviously increased.
Migration As A Solution?
Well given that a strategy of relying exclusively on fiscal tightening and strong deflation is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints somewhat via an open-the-doors policy towards inward migration and with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.
However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these has already been mentioned: that this may ultimately put downward pressure on unskilled workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a “slightly positive” impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.
A further difficulty is the lack of availability of accurate data on the actual scale of either inward or outward migration in Latvia (this difficulty is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad - mostly in the UK and Ireland - but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).
Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latvia’s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either “very likely” or “somewhat likely” to go to another country for work “in the next two years”. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.
But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table below.
(please click over image for better viewing)
Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.
In fact, if we look at the chart below, we will see that during 2003 the rate of out migration from Latvia seems to have dropped substantially, and given what we know about the post 2004 out migration boom, this, on the surface, seems strange.
(please click over image for better viewing)
The answer to this puzzle is to do with the Russophone population who are not Latvian citizens (and therefore logically at this point not EU citizens either). The majority of the pre 2004 out-migration was actually towards the CIS, and it is reasonable to assume that many of these migrants came from the Russian speaking population. And this process is not over as this recent article from Itar-Tass about a joint project to settle Russian speaking Latvian residents in Kaliningrad makes clear.
So clearly the fact that the Latvian authorities may still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere gives an indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.
Yet one more time the difference with Estonia couldn't be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals - which before Parliament by November - which will attempt to address Estonia’s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start.
Towards A Policy Driven Exit
So what is the remedy? Well, lets look again at the IMF proposals:
a) Fiscal policy: Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2¼ percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax.
b) Credit and prudential policies: Sharply curtailing and improving the risk profile of new lending is essential to mitigating macroeconomic and financial stability risks. Rebalancing incentives governing credit growth is therefore essential. The mission supports the effective implementation of the credit-restraining measures in the anti-inflation plan, including fully documenting legal income to secure a loan, establishing a comprehensive register of all loans, and requiring a 10 percent minimum downpayment. We also welcome the recent reimposition of limits on banks' open positions in euros. Additional regulatory measures are also needed to slow credit growth and induce banks to internalize systemic risk in real estate and currency markets. The FCMC, working with the Bank of Latvia, should increase its emphasis on monitoring systemic risk through more frequent on-site inspections of large banks and ensuring that foreign banks tailor their credit-risk models to the Latvian context.
c) Real estate policies: Rebalancing the structure of the economy away from the nontradables sector, especially real estate, is essential to underpin needed current account adjustment. The mission welcomes the increase in real estate taxation envisaged in the anti-inflation plan, as well as the periodic reassessment of cadastral values, beginning in 2007. To be effective, however, enforcement of real-estate related taxation should be stepped up. To further relieve overheating in the construction sector, it will be necessary to significantly scale back government capital expenditure (planned at 5 percent of GDP for 2007)."
d) Labor market policies: Efficient labor utilization is critical to expand aggregate supply and contain surging wage costs, which are contributing to overheating and undermining Latvia's competitiveness. The greater flexibility allowed in the use of fixed-term employment contracts introduced in the 2006 Amendment to the Labor Law is welcome, and further steps to facilitate mobility between jobs and regions are needed. The recent decision to allow unfettered labor market access to the newest EU members may help relieve bottlenecks, and wider temporary access should also be considered.
The above IMF package is clearly a big move in the right direction. My principal worry is that the severity of the shock produced may have a significant longer term impact in a negative direction than is desirable, especially if the package is followed by a bursting of the housing bubble which could in itself precipatate yet another outward stream of migrants. However, as we have seen above, the Latvian government is itself far from accepting the need for the totality of the package, and in particular as regards the fiscal dimension. But I think the big missing issue which is not being addressed here is the labour supply one. A systematic move to apply the fiscal braek, to tighten lending conditions and to facilitate an increased supply of labour would seem to offer a better possibility of bringing about the necessary correction without completely upsetting the apple cart in the process, so I therefore think that such labour supply measures should now be considered as a matter of urgency.
Hard landing?
Of course debating the niceties of the policies we would like to see is one thing, and addressing the economic realities of the policies we have is another. If domestic demand does not abate steadily now, a hard landing could well result. Under this kind of scenario, one or two more years of GDP growth in excess of an annual 10% rate would probably lead to such pressure on the labour market (remember the unemployment rate was dropping in 2006 by about 2.5% a year) and thus to such an acceleration in inflation that the impact on competitiveness and external liabilities would become unbearable. Under these circumstances attracting the necessary external financing would become increasingly difficult, and a sharp slowdown would probably result as the underlying accumulated output gap was corrected in an unduly short space of time. The most worrying point about such a scenario is that we really don't know the long term consequences it might induce. Latvia - like many East European and Central Asian societies is about to experience a severe demographic challenge, and it would be better to face that challenge with the wind behind you rather than the wind in your face, and certainly better to try and chart your own course than head off in the direction of "destination unknown".
References
Inflation in Latvia: Causes, Prospects and Consequences, by Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics.
Statement by IMF Mission to Latvia on 2007 Article IV Consultation Discussions, May 2007.
Republic of Latvia: 2006 Article IV Consultation - Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Latvia, October 2006
Republic of Latvia: Selected Issues, IMF October 2006
Language Use and Intercultural Communication in Latvia
Inese Ozolina
"Changes of Ethnic Structure and Characteristics of Minorities in Latvia"
by Peteris Zvidrins
'Exit' in deeply divided societies : regimes of discrimination in Estonia and Latvia and the potential for Russophone migration. Hughes, James (2005) Journal of common market studies, 43 (4). pp. 739-762. ISSN 1747-5244
Estonian Report on Russian Minority
Aksel Kirch
Latvian Naturalization Board, Statistical Information on Acquisition of the Citizenship of Latvia as at May 31, 2007.
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