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Wednesday, July 29, 2009

Is It Hot In Latvia In August?

Well the big news this morning is that the IMF mission to Latvia has finally reached agreement with the Latvian government on a new policy package that will give the country access to about $278 million in new financing. Details of the deal are scant at the moment, since the Letter of Intent will not be published until the IMF board approves the agreement, but it seems the terms of the IMF deal are (on the face of it) tough: additional budget cuts worth a reported 500 million lats ($1.02 billion) for 2010, a progressive income tax with the possibility of an increase in VAT if the cuts do not reduce the budget deficit to the stipulated level.

Really, this agreement changes very little in my opinion. As Capital Economics' Neil Shearing points out, many people are assuming that with the rapid Current Account adjustment in many CEE countries, the threat to external financial stability has largely gone away. But as Neil argues, while theoretically, it should be enough for the countries just to move back to balance, practical experience from Argentina etc suggests that as recovery arrives the CA tends to move from large deficit to large surplus. And this of course means exports growing at a much faster rate than imports. This is the only practical way to pay down the debt.

And as Afoe's own Claus Vistesen puts it:

This is all about the composition of the external balance and what kind of extensions foreign creditors give. Now, the benefit of the peg is of course that you can begin to accumulate foreign assets at reasonable valuation to your liabilities. HOWEVER, the only way to reasonably begin this process is of course to actually begin accumulating those assets and in order to so so, you need productive investment targeted at foreign operations and this is very difficult unless the "internal devaluation" has run its course. Essentially, domestic investment to serve foreign markets are not productive until deflation has taken its toll.

So basically the message is, whatever the final details of the new agreement, stay tuned and keep watching, since all of this is far from over.

Edward Will Not Be Going To Latvia In August

The little news of the day is that I will not be attending the conference on Latvia's economic future which members of the Peoples Party are trying to organise for August, even though I was invited. As the Latvia Daily Diena (Latvian only I'm afraid) which reports on the preparations for the conference puts it "E. Hugh, who declared himself a defender of the lat devaluation, however, declined to participate, adding he'd like to maintain political neutrality." Well, this is fair enough as a presentation of my opinion, but, just for the record, here's what I actually did say.

First of all I would like to say thank you very much for thinking of me and inviting me to your conference....

....while I think a decision to accept the original IMF proposal of a 15% devaluation of the Lat, and pressure the EU Commission into euro entry was the best option last autumn, this is now no longer the situation. So while I was advocating devaluation back then, what I am saying now is that in my opinion devaluation is inevitable at some point, but that it will now be an unholy mess. Serious contagion problems will most likely ensue, and so in this sense I am no longer "advocating" Latvian devaluation. Ideally it needs to take place as part of a much more general solution to problems in the economies of the Eastern European countries who are members of the EU.

If Latvia is simply forced off the peg, then we should all watch out. I am in Spain, and I am expecting consequences here.

Thirdly, I am not in basic disagreement with the IMF, and would not wish to do anything which may make their work more difficult. Basically, from where I am sitting the issue is to put pressure on the EU institutional structure in an attempt to get them to recognise some of the basic ABCs of economics.

Lastly, I would emphasise that I am an economist, a mere technician of economic systems, and not a politician. I am explicitly non politicial, and am maintaining this stance both vigourously and adamantly.

Basically, as I said, I consider devaluation inevitable..... tomorrow, in August, after Christmas, in 2011, I don't know when. I also know that the longer it is in coming, the more serious the consequences will be, due to the continuous degradation in the credibility of the associated institutions (IMF, ECB, EU Commission, EBRD etc). This is all now quite likely to eventually become (via the other Baltic states, Bulgaria, Hungary, Romania and even Ukraine and Serbia) a very serious problem, with potentially major global implications.

So there will be a before and after. After devaluation there will need to be a major rethink about where Latvia is going. Devaluation is not an end in itself, it is simply a means to an end, a begininning. We also need to think about how Latvia will earn its living, pay off its debts, and find its way in the world.

Long term structural, and strategic economic thinking are needed.

Here I think I do have a part to play. As you may well have noticed, my view is that the ongoing demographic deterioration of your country lies at the heart of your macro economic problems.

I think this deterioration needs to be addressed as soon as possible, and I see three large issue.

i) Productive capacity needs to be increased substantially. This means increasing the labour force, and this means (as outlined in the World Bank Report, From Red To Grey) facilitating large scale inward migration. Given the serious political implications of encouraging ethnic Russian migration into your country, I see only two viable source regions, the Central Asian Republics in the CIS, and Sub. Saharan Africa. Possibly this solution will not be widely popular with Latvian voters. Well, they do have the right to choose. Your country can take the measures needed to become sustainable, or you can watch it die, as the economy shrinks, and the young people leave. That, I think, is your choice.

The other two measures you need to take are contingent on the first being implemented, since without the first measure you will simply not dispose of the economic resources for the other two.

ii) A serious policy to support those Latvian women who do wish to have children. But with major financial advantages, not half measures, and propaganda stunts. You need policies that can work, and I know plenty of demographers with ideas.But this needs money. Important quantities of money. And gender empowerment, right across the economy, at every level. We have formal legal equality in the labour market, but evident biological and reproductive inequality, in that only one of the parties gets to bear the children. The institutional resources of the state need to redress this imbalance.

iii) Major reforms in the health system to address the underlying male life expectancy problem. You can only seriously hope to raise the labour force participation rates at 65 and over if people arrive at these ages in a fundamentally healthy condition. In economic terms, simple investment theory shows why this is the case. A given society spends a given quantity of resources on producing a given number of children, those who have citizens who live and work longer evidently get a better return on their investment. If you want to raise Latvian living standards, you have to raise the life expectancy. And this apart from the evident human issues.

OK, I am saying no for the moment, but I would like to stress that when conditions change, I would be more than willing to come to your country to try to help. But not for a day, for a month, and not to give a talk, but to work with some serious people who are willing to roll their sleeves up and do the serious spadework that will be needed to find those solutions you so badly need.

Basically, my feeling is that the issues you face are so complex that public debate is unlikely to produce a very fruitful outcome at this point. You need a long term education process, and for the time being more or less technocratic solutions, but not the technocratic solutions you are being offered by the EU now (which basically won't work), technocratic solutions which get to the heart of the problem and set your country on a sustainable path.


romanz said...

This (future growth while continuously deteriorating demographic situation) is a challenge indeed - I fully agree. I am thinking about it for a long time and yet do not see an easy solution. Over the past years, my fellow Latvians have indeed demonstrated unwillingness to have more than one child, along with easy attitude towards changing country of residence. In light of the widely expected lack of employment and higher taxes in the future, this perhaps is _the_ problem, perhaps as important or even more important than widely discussed short-term monetary or fiscal decisions.

But then I'm also thinking....

(i) Latvia has an enormous potential for productivity increase. I repeat: enormous. In all sectors. I am lucky to be in property development these days, and compared to construction sites across Europe, I see 2-3 times more people on our site. One's working, the other two - smoking... Look at the streets - they're all cleaned by a guy with a broom and not on a little bobcat. Where are self-service tills in supermarkets? I'm not even mentioning lack of municipal and government e-services. Et cetera, et cetera...

(ii) What about agriculture? Our country has vast amounts of empty land, yet somehow, a lot more often I come across a cultivated field in Lithuania. Why do our tomatoes cost 50% more than those Dutch ones? You can make agricultural production quite labour-unintensive, too.

(iii) What about transit? Other industries?

You say, bring more labour. I say, here it is - 1 in 5 is already unemployed. I say, make the right investment, make it more efficient, make existing labour more productive. The time has come.

What I think is the biggest problem in this country is the absence of vision. What is Latvia? What are Riga, Ventspils, Daugavpils? What's their comparative advantage? Is it a port city, an industrial city, a tourist destination, cultural city, financial centre - what? And because people do not see it or hear it, their mind is focused on the little problems of today's, without knowing where it's going.

We need to set the priorities. People of Latvia have to share vision of what the country will be in 10, 20 years. If someone tells me it's going to be a country of 500 thousand people all in agriculture, and if everything happening around me, all political decisions that are made, if all of that's in line with this same vision, and there're no sudden changes of path every year - then be it. I know it and I act accordingly. And that's when (and only then) I can make a long-term investment, too. And so can everyone else. Unfortunately, this far, that someone is telling me Latvia is that, and this, and a bit of this, and then also that. And then that someone's sent home and another someone's there to turn things upside down again, and start saying completely something else now...

Anonymous said...

I would like to see you there.. Finaly You are not living in a Dream and Your Analyses are 100% Science and not politics.

Anonymous said...

From Riga
thanks for You opinion. I agree with your theses and, however, see no political chance to change this. The reason is quite easy. In Latvia every immigration politics is not able to put through. There was after the First World War the disaster of the mass emigration of German professional forces and capital from the country, the country was cut off actually by all old markets and up to the world war 2 the country, nevertheless, was not willing to negotiate with Germany, Poland or the Soviet Union . The country has simply ignored Germans because of political motivation, Polish and also Russian interests with the result the country in many points became extinct. After the Second World War were settled because of the awful human losses a gigantic number of young women from Slavic parts of the USSR to substitute the manpower. This was at the end of the Soviet Union a gigantic problem. The ethnic Latvians had another image of state and were to be locked up again Ready the country or at least an artificial mass emigration of Russian-speaking population parts would be welcome (As well as the Germans after the First World War).
In a country inhabited only half by ethnic Latvians. a new mass immigration cannot be put through politically. the élites strongly believe inside (and so the mayority of etnic Latvians) that nationalism is more important than macroeconomics... This was already very often proved and will be further proved. Latvia is also nice with 500,000 people. The country will look different just again. Who do remember the Germans? the Jews or many Poles from Riga, Scots and Englishmen from Vientspilsin the country 100 years ago.. they where elem. part of Latvia. the country very much stamped by them. Maybe the Russian-speaking population will also disappeare in 100 years. We will see

Andris said...

@Riga Anonymous

The difference of today. We are neither taken by an order of knights and also not by Russian tanks. Nobody let immigrant inside our country. We have to do something do that our generation get a chance in our country. Of my final year at school, and I was born in 1985,of 27 15 do stay allready abroad. Most for good, and why? because of our politicians our country become impoverished. It will go even more. This is a disgrace. I am an architect if I a chance agree then I also disappear from Latvia. I earn 1/4 less money than one year ago and have also got the last year only half like an architect in Germany

Kaspars V said...

Edward, I admire your posts, dedication to cause and experience very much. I sincerely hope that those in power find a way to involve you to create a sensible policy to enable recovery as fast as possible and enable sustained growth.

Edward Hugh said...

Hello everyone,

I would just like to say thank you for all these very interesting and encouraging comments. I am on holiday at the moment, and rather pressed for time. I will try to fine space on Sunday and try to write some extended considerations on the issues you have raised.

Reinis said...

Just to give Edward and others not in Latvia some "local" insight on this "conference on Latvia's economic future" organized by Peoples Party.

Peoples Party ("Tautas partija" in Latvian) has been in power for most of the time since 1999 and only recently (December 2007), when economical turmoil was just about to start, they gave up chair of prime minister. Currently the popular opinion in Latvia is to blame those guys for trouble we are in, since they were CEOs and CFOs of Latvia for almost a decade and as it currently seems - they failed miserably. Given opinion is largely based on fact that party managed to become so powerful and successful by masterfully feeding itself of the government spending (both direct and indirect). Furthermore there are speculations on deliberate increases in government spending just to cover certain private interests.

Now what happens when IMF comes in as asks to cut government spending? All the attempts to cut the costs meet really heavy resistance from bureaucratic machine that Peoples Party have so successfully built (out of it's own members) during last 8 years. And the same goes to all of businesses that those guys have built around government spending while engaging in conflict of interests. As result IMF demands had largely to be realized on cost of VAT, social security, health care, etc..., while preserving self interests as much as possible.
Of course it would be naive to say that given party is the only culprit, but as popular opinion currently goes they seem to be the biggest one. And this results in dramatic popularity drops. The dislike even went even so far, that you could see graffiti in Riga's streets with Peoples Party logo and text "People, hang the party". So Peoples Party has now engaged in kind of "survival" mode and attempting all kind of strange PR moves (latest one was being only government party to refuse to sing IMF memorandum and then accepting to sing it at end of same day). So it could well be that given conference is just another one of those, rather than genuine interest to discuss "economic future".

Therefore I can only applause authors stance on maintaining political neutrality.