Lessons from the Latvian austerity program

Martins Bitans Bank of Latvia 18 April 2013

1

Expansionary fiscal contraction • Giavazzi, Pagano (1990): The Danish experience shows that cuts in

government spending can be associated with increases in consumption;

• Blachard (1990): Sometimes, decrease in spending or an increase in taxes indeed increases demand, consumption and output. The questions are that of when and how;

• Alesina and Ardagana (1997): Fiscal tightening produces (non-Keynesian) expansionary effects. One interpretation is that a serious fiscal tightening increases demand;

• Alesina and Perotti (1998): Fiscal corrections relying mostly on spending cuts that are concentrated on government wages and transfers tend to be expansionary ;

• Alesina and Ardagana (2009): We uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions.

2

Expansionary fiscal contraction : critique

• IMF WEO (October 2010): Fiscal consolidation typically reduces output and raises unemployment in the short term. Over the long term, reducing government debt is likely to raise output.

• DeLong and Summers (2012):Need for considerable caution re-garding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound

• Blanchard and Leigh (2013): Stronger planned fiscal consolidation associated with lower growth than expected.

• Krugman (2010): What sounds like hardheaded realism actually rests on a foundation of fantasy, on the belief that invisible vigilantes will punish us if we’re bad and the confidence fairy will reward us if we’re good.

3

Fiscal Policy Changes and Economic Growth in Latvia

-10

-7.5

-5

-2.5

0

2.5

5

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

2008 2009 2010 2011 2012 2013 (f)

Cyclically adjusted government balance (% of GDP), RHS

GDP growth (%), LHS

Source: EC, CSB Latvia 4

HAS FISCAL AUSTERITY WORKED IN LATVIA?

5

Main problem of the boom years – unsustainable current account position

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Savings, Investments and Current Account Balance in Latvia (% of GDP)

Current account Savings Investments

• Current account (by identity) is the difference between income and consumption, but also the difference between domestic savings and investment

• Current account deficits can be reduced by increasing savings (lower consumption) or lower investments

• Both approaches imply GDP will inevitably decline

6

In two years from 2008-2010, GDP declined by almost a quarter…

Real GDP, 4 quarter moving average (1Q 2007=100)

80.0

85.0

90.0

95.0

100.0

105.0

110.0

20

07

Q1

20

07

Q2

20

07

Q3

20

07

Q4

20

08

Q1

20

08

Q2

20

08

Q3

20

08

Q4

20

09

Q1

20

09

Q2

20

09

Q3

20

09

Q4

20

10

Q1

20

10

Q2

20

10

Q3

20

10

Q4

20

11

Q1

20

11

Q2

20

11

Q3

20

11

Q4

20

12

Q1

20

12

Q2

7

… but much of it was correcting for

previous (unsustainable) excesses

75.0

100.0

125.0

150.0

175.0

200.0

Actual GDP

Long-term trend

Real GDP, 4 quarter moving average (1Q 2000=100)

8

Assessing devaluation options

88

90

92

94

96

98

100

102

104

2008 2009 2010 2011 2012 2013

GDP with fixed peg: IMF assessment

GDP with wider fluctuation bands: IMF assessment

GDP with wider fluctuation bands: BoL assessment

9

Structure of Domestic Loans (%)

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

100% 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

LVL EUR USD other 10

Impact of devaluation on the banking system

12 12.4

0

23.8

7.2 6

43.6

-5.6

17

-10

-5

0

5

10

15

20

25

30

35

40

45

Share of loans overdue (more

than 90 days)

Capital adequacy ratio Number of banks with CAR

lower than 8%

As of 30.06.09 With 15% devaluation With 30% devaluation 11

Today Latvia is again the fastest growing EU country, but this time with sound fundamentals

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

Latv

ia

Lith

uan

ia

Esto

nia

Po

lan

d

Slo

vaki

a

Bu

lgar

ia

Mal

ta

Au

stri

a

Swe

de

n

Ge

rman

y

Ire

lan

d

Ro

man

ia

Luxe

mb

ou

rg

Un

ite

d K

ingd

om

Fran

ce

Be

lgiu

m

Fin

lan

d

Euro

pe

an U

nio

n

De

nm

ark

Net

he

rlan

ds

Cze

ch R

ep

ub

lic

Spai

n

Hu

nga

ry

Slo

ven

ia

Ital

y

Cyp

rus

Po

rtu

gal

Gre

ece

GDP growth in 2012 (% y-o-y)

12

Source: Eurostat

Average annual growth in 2004-2014: Latvia 3.4% vs Iceland 2.3%

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 (F)

2014 (F)

Latvia

Iceland

GDP growth, %

Source: Eurostat

13

Real GDP: Latvia vs Iceland (1Q 2004=100)

95

100

105

110

115

120

125

130

135

140

145

150

20

04

Q1

20

04

Q4

20

05

Q3

20

06

Q2

20

07

Q1

20

07

Q4

20

08

Q3

20

09

Q2

20

10

Q1

20

10

Q4

20

11

Q3

20

12

Q2

20

13

Q1

20

13

Q4

20

14

Q3

20

15

Q2

20

16

Q1

20

16

Q4

Latvia

Iceland

14

WHY HAS FISCAL AUSTERITY WORKED IN LATVIA?

15

Blanchard (1990) • Fiscal consolidation has two effects:

– increases tax burden and reduces consumption (strength depends on how far economy departs from Ricardian equivalence)

– by reducing deficit today the government eliminates the need for more adjustments in the future

• When would expect a fiscal consolidation to increase rather than decrease output? – when the first effect dominates the second

• This is more likely under two conditions: – small effects of intertemporal tax reallocation

• consumers more Ricardian if credit markets developed

– when the economy is closer to the brink (of insolvency)

• debt approaching critical levels

16

Bond yields vs government debt in 2009

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

30.0 35.0 40.0 45.0 50.0 55.0

Go

vern

me

nt

lon

g-te

rm b

on

d y

ield

s (%

)

Government debt (% of GDP)

LV

17

Debt projections for Latvia: where is the critical threshold?

0

20

40

60

80

100

120

140

Public sector debt

Scenario under the program adjustment

Scenario with no policy change

Source: IMF, First Review under IMF Stand-By Agreement; September 2009 18

Yields on long-term government bonds: Latvia vs Germany

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

20

06

M0

1D

02

2

00

6M

03

D0

8

20

06

M0

5D

12

2

00

6M

07

D1

8

20

06

M0

9D

21

2

00

6M

11

D2

7

20

07

M0

1D

31

2

00

7M

04

D0

6

20

07

M0

6D

12

2

00

7M

08

D1

6

20

07

M1

0D

22

2

00

7M

12

D2

6

20

08

M0

2D

29

2

00

8M

05

D0

6

20

08

M0

7D

10

2

00

8M

09

D1

5

20

08

M1

1D

19

2

00

9M

01

D2

3

20

09

M0

3D

31

2

00

9M

06

D0

4

20

09

M0

8D

10

2

00

9M

10

D1

4

20

09

M1

2D

18

2

01

0M

02

D2

4

20

10

M0

5D

13

2

01

0M

07

D2

8

20

10

M1

0D

04

2

01

0M

12

D0

9

20

11

M0

2D

16

2

01

1M

04

D2

6

20

11

M0

7D

05

2

01

1M

09

D0

8

20

11

M1

1D

17

2

01

2M

01

D2

5

20

12

M0

4D

03

2

01

2M

06

D1

3

20

12

M0

8D

17

2

01

2M

10

D2

3

20

13

M0

1D

03

Germany

Latvia

19

General Government budget balance (ESA’95), % of GDP

-1.6 -2.9

-5.6 -6.9 -6.4

-3.1

-0.8 -1.3 -0.9

-20

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2005 2006 2007 2008 2009 2010 2011 2012F 2013F 2014F

Consolidation effort Actual (targeted) balance

Structural budget balance (PF) Source: Eurostat, F – Bank of Latvia staff estimation

20 20

Breakdown of budget consolidation measures, % of GDP

Source: Ministry of Finance; Bank of Latvia staff calculations 21

ULC adjustment through lower wages, but also higher productivity

80

120

160

200

240

20

00

Q1

Q3

20

01

Q1

Q3

20

02

Q1

Q3

20

03

Q1

Q3

20

04

Q1

Q3

20

05

Q1

Q3

20

06

Q1

Q3

20

07

Q1

Q3

20

08

Q1

Q3

20

09

Q1

Q3

20

10

Q1

Q3

20

11

Q1

Q3

20

12

Q1

Nominal ULC Real ULC

Unit labour cost index (2000 Q1 = 100; seasonally adjusted)

-23%

-28%

22

Adjustment in economy supported by flexible labour market framework

16

0 20 40 60 80

100

De

nm

ark

Swe

de

n

Fin

lan

d

Cyp

rus

Mal

ta

Be

lgiu

m

Luxe

mb

o…

Slo

ven

ia

Au

stri

a

Ire

lan

d

Ital

y

Gre

ece

Ro

man

ia

Slo

vaki

a

Un

ite

d …

Cze

ch …

Ge

rman

y

Net

he

rlan…

Bu

lgar

ia

Hu

nga

ry

Latv

ia

Po

lan

d

Spai

n

Po

rtu

gal

Lith

uan

ia

Esto

nia

Fran

ce

20

0 20 40 60 80

100

Au

stri

a

Be

lgiu

m

Slo

ven

ia

Po

rtu

gal

Fran

ce

Fin

lan

d

Swe

de

n

Net

he

rl…

Gre

ece

Spai

n

De

nm

ark

Ital

y

Cyp

rus

Ge

rman

y

Luxe

mb…

Mal

ta

Cze

ch …

Ire

lan

d

Po

lan

d

Slo

vaki

a

Un

ite

d …

Ro

man

ia

Bu

lgar

ia

Esto

nia

Hu

nga

ry

Latv

ia

Lith

uan

ia

Collective bargaining coverage (%)

Trade union density, %

Source: www.worker-participation.eu

23

Economic and export growth underpinned by restored competitiveness as wage-productivity gap has been closed

70

90

110

130

150

20

00

Q1

Q3

20

01

Q1

Q3

20

02

Q1

Q3

20

03

Q1

Q3

20

04

Q1

Q3

20

05

Q1

Q3

20

06

Q1

Q3

20

07

Q1

Q3

20

08

Q1

Q3

20

09

Q1

Q3

20

10

Q1

Q3

20

11

Q1

Q3

20

12

Q1

Q3

Labour productivity Real wage

Wage and productivity index (2005 Q1 = 100, seasonally adjusted)

Source: Central Statistical Bureau of Latvia data, Bank of Latvia staff calculations (2012 Q4: flash productivity data) 24

Exports in Latvia growing faster than in countries where currency depreciated

Exports of goods and services (in euros), 2006=100

60.0

80.0

100.0

120.0

140.0

160.0

180.0

2006 2007 2008 2009 2010 2011

Latvia

Sweden

United Kingdom

Iceland

Poland

Estonia

25

CAN FISCAL AUSTERITY WORK ELSWHERE?

26

All PIIGS countries had vulnerable government debt positions

-30

-20

-10

0

10

20

30

40

50

60

0 20 40 60 80 100 120 140

Exp

ect

ed

ch

ange

s in

go

vern

mn

t d

eb

t (%

of

GD

P),

20

09

-20

16

Government debt in 2009 (% of GDP)

Source: IMF WEO April 2010

LV IE

IT

GR

PT

SP US

BE

FR

UK

Hazard

zone

Hazard

zone

27

Potential credibility gains before adjustment: largest in Greece, smallest in Italy

-4

-2

0

2

4

6

8

10

0 20 40 60 80 100 120 140

Spre

ads

on

go

vern

me

nt

bo

nd

yie

lds

vis-

a-vi

s G

erm

any

(% p

oin

ts),

20

10

Government debt (% of GDP), 2009

IT

PT

GR

IE

ES

LV

Source: IMF 28

4. Relationship between Government Debt and Bond Yields in Selected European Countries

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

0 20 40 60 80 100 120

10

Y G

ove

rnm

en

t b

on

d y

ield

s

Expected gross government debt in 2017 (% of GDP)

Advanced EU

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

0 20 40 60 80 100 120

.

.

CEEC

Source: Eurostat, ECB, IMF

29

When does Keynesianism work? • Total demand in the economy significantly below total

supply

– in Latvia, both demand and supply contracted

• Extra government spending can be financed

– Latvia had not accumulated budget surpluses during the boom years

– markets were not able or willing to finance government spending almost at any cost

• Stable money demand

– in Latvia, national and foreign currencies are close substitutes

• Relatively closed economy

– in Latvia, imports account for a significant share of total income

30

How counter-cyclical was fiscal policy during the boom years

-8

-7

-6

-5

-4

-3

-2

-1

0

Spain Ireland Latvia Italy Portugal Greece

Structural budget deficit (average 2004-2008, % of GDP)

Source: EC 31

Countercyclical fiscal policy must be countercyclical throughout the cycle, not just

during the downturn

FI

DK SE

BG

LU

ES

NE

IE

EE

BE

CY

AU

DE

SK SI

CZ

LV

LT FR

PL

IT

UK

RO

MT

PT

GR

HU

-1

0

1

2

3

4

5

6

7

-8 -6 -4 -2 0 2 4 Ch

ange

s in

str

uct

ura

l bal

ance

20

13

-20

11

(%

of

GD

P)

Average structural balance 2004-2008 (% of GDP) Source: EC

32

Labour market flexibility

0

10

20

30

40

50

60

70

80

90

100

Latvia Ireland Greece Spain Italy Portugal

Collective bargaining coverage (% labour force)

33

Source: www.worker-participation.eu

Openess to foreign trade

0

20

40

60

80

100

120

140

160

180

200

Latvia Ireland Greece Spain Italy Portugal

Exports and imports of goods and services (% of GDP)

34 Source: Eurostat

Estimating chances of expansionary fiscal consolidation

Debt before adjustment

Spread before adjustment

Flexibility of labour markets

Openness to trade

Frontloading of fiscal adjustment

TOTAL

Latvia 36.7 9.14 20 126 6.4 HIGH

Ireland 92.2 3.0 35 192 6.2 HIGH

Portugal 93.5 2.66 94 77.9 4.8 MEDIUM

Italy 119 1.3 80 59.4 1.6 LOW

Greece 148 6.35 85 59 4.1 MEDIUM

Spain 61.5 1.51 82 63.8 -0.5 LOW

35

A LOOK INTO THE FUTURE

36

Forecasts of GDP growth in 2013 for Latvia (%)

2.4

2.6

2.8

3

3.2

3.4

3.6

3.8

4

no

v.1

1

de

c.1

1

jan

.12

feb

.12

mar

.12

apr.

12

mai

.12

jūn

.12

jūl.1

2

aug.

12

sep

.12

okt

.12

no

v.1

2

de

c.1

2

jan

.13

feb

.13

mar

.13

EC

IMF

Consensus

37

Economic growth in Latvia generated by exports and private consumption

-40 -35 -30 -25 -20 -15 -10

-5 0 5

10 15 20 25

2005 2006 2007 2008 2009 2010 2011 2012

Imports

Exports

Investments

Government consumption

Private consumption

GDP

Contribution to GDP growth (% points)

Source: Statistics Latvia 38

Decline in credit stock reflects still ongoing deleveraging

Credit to private sector (y-o-y, %)

Source: Bank of Latvia

39

-20

0

20

40

60

80

100

I 2

00

4

IV

VII

X

I 2

00

5

IV

VII

X

I 2

00

6

IV

VII

X

I 2

00

7

IV

VII

X

I 2

00

8

IV

VII

X

I 2

00

9

IV

VII

X

I 2

01

0

IV

VII

X

I 2

011

IV

VII

X

I 2

01

2

IV

VII

X

I 2

01

3

Annual growth of household credit stock

Annual growth of nonfinancial corporation credit stock

Annual growth of resident credit stock (without government)

Deleveraging in the banking system continues, limits loan growth

Loan-to-Deposit Ratio in Latvia (%)

100

150

200

250

300

350

I 20

05

V

II I 2

00

6

VII

I 20

07

V

II I 2

00

8

VII

I 20

09

V

II I 2

01

0

VII

I 20

11

V

II I 2

01

2

VII

Total Foreign banks

Domestic banks

Loan growth in Latvia (%)

Source: Bank of Latvia

-20

-10

-

10

20

30

40

50

I 2008

VII I 2009

VII I 2010

VII I 2011

VII I 2012

VII

Contribution to lending growth by foreign banks (% points) Contribution to lending growth by domestic banks (% points) Total lending growth (%)

40

Confidence indicators strong, but for how long?

Economic Sentiment Index (ESI)

80

85

90

95

100

105

110

115

I 2010

V IX I 2011

V IX I 2012

V IX I 2013

Latvia

Lithuania

Estonia

Source: EC 41

Euro: why now?

42

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

IV 2

011

V

VI

VII

VII

I

IX

X

XI

XII

I 2012

II

III

IV

V

VI

VII

VII

I

IX

X

XI

XII

I 2013

II

III

IV

12m average inflation in Latvia Estimated Maastrich criterion*

1.6

2.9

Maastricht reference value for price stability will be reached with a significant margin in Latvia

Estimates of 12 month average inflation and the Maastricht criterion, %

Sources: Eurostat, EC, Bank of Latvia estimates * - Greece excluded from calculation 43

Actual and estimated inflation: Latvia vs EU best inflation performers (%)

Jan.13 Feb.13 Mar.13 Apr.13*

Annual inflation Latvia(%) 0.6 0.3 0.3 0.4

12 month average inflation in Latvia (%) 2.05 1.81 1.57 1.36

12 month HCPI inflation (%):

Sweden 0.93 0.89 0.84 0.80

Ireland 1.95 1.92 1.78 1.68

Germany 2.11 2.05 2.01 1.98

Denmark 2.22 2.08 1.91 1.78

France 2.13 2.02 1.89 1.78

Maastricht criterion (Greece assumed as outlier) (%)

3.1 (SE, IR,

LV)

3.0 (SE, LV,

IR)

2.9 (SE, LV,

IR)

2.8 (SE, LV, IR)

* BoL forecasts 44

Interest rate criterion scenario analysis

Jan.13 Feb.13 Mar.13* Apr.13*

12 month average interest rates in Latvia (%) 4.35 4.17 4.00 3.84

12 month average interest rates (%):

Sweden 1.60 1.61 1.61 1.63

Ireland 5.88 5.61 5.35 5.09

Germany 1.47 1.44 1.42 1.41

Denmark 1.39 1.38 1.37 1.37

France 2.45 2.39 2.33 2.27

Maastricht criterion (LV, SE, IR), % 5.94 5.80 5.65 5.52

Maastricht criterion (LV, SE), % 4.98 4.89 4.81 4.74

Maastricht criterion (LV, SE, FR), % 4.80 4.72 4.65 4.58

Maastricht criterion (LV, SE, DK), % 4.45 4.39 4.33 4.28

* BoL forecast 45

Contribution of main components to the annual average inflation, pp

2.3

1.3

2.6 2.4

-1

0

1

1

2

2

3

3

2012 2013 2014 2015

Fuel

Unprocessed food

Regulated prices

Core inflation

Annual average inflation

Source: Central Statistical Bureau of Latvia, forecast - Bank of Latvia staff estimation

46

Euro zone’s policy response to crisis

POLICY AREA BEFORE THE CRISIS NOW

Monetary policy Liquidity support Lender of last resort

Coordinated financial assiatance

None European Stability Mechanism

Fiscal policy Stability and growth pact (SGP)

Enhanced SGP (Fiscal Compact, European Semester)

Banking National supervision Coordinated supervision (banking union in the future?)

47

Policy coordination is good but market discipline is essential

2008

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

0.0 25.0 50.0 75.0 100.0 125.0

Go

vern

men

t b

on

d y

ield

s (%

)

Government debt (% of GDP)

2012

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

0.0 25.0 50.0 75.0 100.0 125.0

Go

vern

me

nt

bo

nd

yie

lds

(%)

Government debt (% of GDP)

48

Summary: costs and benefits of joining versus waiting

Latvia joins the euro in 2014 Latvia waits

Banking sector problems solved, growth in the euro zone picks up

•Latvia benefits from lower interest rates, additional investment

•Higher interest rates hamper growth. •Risks of marginalization

Euro zone continues “muddling through” the crisis

•Lower interest rates •Participation in EMS, but money not lost •Latvia paticipates in designing euro zone policies

•Uncertainty leads to higher interest rates •Ultimately costs of joining (EMS) the same or higher •Will adopt policy framework which was designed without Latvia

Euro zone disintegrates •Latvia suffers severe macro consequences •Extra costs of currency re-introduction •Some payments into EMS may be lost

•Latvia suffers severe macro consequences

49