Hard Or Soft Landing in Latvia?

The Batic Times had an article during the week which offered a summary of a recent report from Hansabank Markets (full text available here in event of link rot).

Now as Latvian Abroad points out in comments, neither the article nor the report it summarises really add anything new to the the extensive airing that this topic has already received in the economic and financial press. In this context see, for example, the Financial Times here and here, the Economist here, here and here, and EU Business here. EU Economy Commissioner Joaquim Almunia has also joined in the act, although he explicitly avoided direct reference to the hard landing possibility, as did the IMF staff economists in their last IMF "Mission to Latvia" statement. The same essentially goes for the widely quoted BICEPS report (caution pdf). Carsten Valgreen, who puts his finger on one part of the present problem judiciously avoids voicing an opinion about what exactly the future might have in store for Latvia.

Hansabank, however, is rather more explicit than most, and this explicitness isn't too hard to understand, since they come down on the more optimistic side of the fence.

The Estonian and Latvian economies are settling into the eagerly awaited “soft landing,” as Estonia’s growth in the first quarte of this year eases off a rapid 9.8 percent year-to-year increase, and Latvia’s slows from 11.2 percent, says a new report released by Hansabank Markets.

Perhaps this optimistic tone is not all that surprising, given the amount of money Hansabank have invested in the happy ending scenario. The report also touches on the rather more delicate issue of the currency peg, and what might happen to it. Again they are pretty positive.

Anxiety this spring of a possible devaluation of Latvia’s currency due to the rapidly deteriorating balance of trade figures has subsided as well. Chief Economist at Hansabank Martins Kazaks says, “The risk of devaluation is minor at the moment. Due to our very thin and virtually sealed-off financial markets, external speculative attacks are very unlikely to be of any important volume, but with no improvements in macro imbalances the current situation is not sustainable.”

The last phrase, we might note. does cover virtually any possible eventuality.

But, more to the point, what exactly are these macro imbalances they refer to? Well as I have tried to argue at some length here, they stem from a virtually unique set of circumstances (historically unique I mean, at the present time the underlying dynamic across all the East European EU member states is remarkably similar, with the possible exception of Hungary). In brief Latvia is facing, at one and the same time, a massive inflow of external funds, and a massive outflow of people. Put another way, demand side factors are increasing rapidly, while supply side capacity not only is unable to keep pace, it is actually shrinking (if we think about the number of people of working age).

So there are two problems to correct here, and they are both large and important. Essentially Latvia needs:

a) more labour supply, both skilled and unskilled
b) a lower rate of inflow of structurally distorting funds, whether these be bank credit, remittances, or even (possibly, this needs investigating further) EU funding for projects which Latvia cannot reasonably expect to carry through in the time horizon outlined.
c) more Foreign Direct Investment to create value creating jobs, especially in manufacturing and services areas with export potential
d) increased spending on education and training projects to upgrade the human capital of the existing population

In this sense the Hansabank statement that:

"The main risk.....is if governments continue expansionist policies, and in the process fuel ongoing consumer spending growth."

is not really to the point, since it is not government policy which is fueling the overheating, and indeed the government is already aiming for a budget surplus this year. In this sense the Hansabank report only reiterates what the IMF staff economists stated after their Article IV consultation discussions back in May 2007, to the effect that the Latvian government should aim for a 4% of GDP budget surplus in 2007, an order of magnitude which the Latvian government has so far resisted. So the Latvian government may be blamed for excessive complacency. The March 2007 measures (summarized by the Finance Ministry here, and by the National Bank here) certainly fall short of what is needed, but at the same time it needs to be understood that many of these problems are not of the Latvian governments own making, and even under the best possible package of policy options, Latvian would still be having major problems, as the BICEPS report authors indicate when they state that Latvia has more problematic parameters than policy instruments available. This is simply a technical way of saying that they are really rather at the mercy of events, and not their master.

The central point here is that the fiscal surplus proposal really a form of positive policy, it is a last line of defence move, implemented as a result of the fact, as the BICEPS report makes clear, that given the fact that the major imbalance issues (shortages of suitably educated and qualified working population, and inflow of remittances and bank funds) are de facto outside of the control of conventional monetary policy instruments, neither the central bank nor the government have adequate policy instruments available. This is the real issue, and this is the longer term problem we all need to be thinking about, not only in Latvia but far more generally.

But the measures mentioned above are longer term and structural, what about the present situation, is it manageable? This is a very difficult question to answer. It depends on what they call the "global conditions". The financial markets, as is now well known, are currently in turmoil, and it is hard to know where the snowball which has been put in motion will actually come to rest. But to really decide whether or not the Baltic states will have a hard landing we really do need to know, as a prior, the answer to this question. Meanwhile, we must simply bide our time, and watch and wait.

My general feeling is that while there are no easy or immediate solutions to Latvia's long term problems, Latvia on its own won't "unwind". Nor is it likely to precipitate a more general unwind. In part this is to do with what the Economist rather impertinently calls the "pipsqueak" factor.

But then we need to think about the general global risk appetite. Certainly this has been somewhat volatile of late. And for the time being it seems set to remain volatile.

The issue really is that the global economy may be reaching(or even we may now have passed) the peak of the current growth cycle. Signs of a slow-down are evident everywhere (except of course in Eastern Europe, although obviously the Baltics and Hungary are clearly slowing now, and the others may not be too long in following depending on how "hard" the global landing actually is). From the US to the eurozone and Japan it is clear that GDP growth rates in 2007 will be lower than those in 2006, and even China is giving some indication that she will need to pause for breath at some point (especially if the rapid growth rates of exports to the EU and the US cannot be maintained), and while India may well be on the development launch ramp, she is not sufficiently large (in GDP terms), or sufficiently integrated in the global economy at this point, to make any decisive difference.

The decline in the value of the dollar is also a factor which needs to be considered here. In Europe we are not especially noticing the oil price effect, but in the US it is surely now a drag. Add to this the US housing woes, and the fact that almost a majority of the population *believe* that the US is headed for a recession ("animal spirits" do matter here). As a result I think it is not unreasonable to imagine that the US will gradually (I hope gradually) slow in the second half of 2007.

If we reach a recession call point in the US then Bernanke will undoubtedly unlease all that ammunition he has been storing up, and start to lower interest rates (Of course the surprise move by the Federal Reserve last Friday is now an early indication of this possibility). This in and of itself will present the ECB with a big headache, given the "normalisation" course they have been trying to steer. Any attempt to continue the upward march in Eurozone interest rates will only send the euro once more sharply upward, and with the euro, of course, the Lat.

But it is more what will happen in financial markets at this point we need to be thinking about.

Once the ECB moves away from rate "normalisation" as a discourse (as I feel it will now have to), and once we get into the area of possibile rate reductions again, then the global financial system will enter a "delicate moment", simply because what financial markets like best is a consistent story, and this is what we have been having, up to now. In the last few years everything has been all about relative yield and the search for the differential. But when we get a change in the "zeitgeist", then there is always the risk of increased problems, if for now other reason than that market participants don't really know how to respond. This, I think is the worry in the back of the Economist's Buttonwood's mind in the recent articles (here, and here). As he says in the most recent installment - Cold Turkey - "WHEN investors get twitchy, developing countries are usually the first to pay the price."

So what can the Latvian government do? Well beyond tightening up credit regulations (which it has already done, but there are limits to this process in an era of financial deregulation) and being more aggressive on the fiscal tightening side, there is precious little they can do. Obviously steps need to be taken to try and facilitate the return of some of those migrants who are in the UK and Ireland (mightn't some of the EU funding be better used for this purpose?), and evidently it would be very positive to follow in the initial footsteps of Estonia and open the labour market up to migrants from elsewhere (indeed they need to be actively encouraged to come, and not subtly resisted), and of course the underlying fertility situation which is fueling the problem needs to be addressed (once more a leaf can be taken from Estonia's book). But all these measures are longer term in nature. In the short term we now have little remedy but to sit it out and wait, and oh yes, to keep our fingers crossed that the current problems associated with the US sub-prime mortgage market don't turn into a globalised and general "credit crunch".