Economic Developments in Latvia and the Way Forward May 29, 2010 Ilmārs Rimšēvičs Governor of the Bank of Latvia

Latvia stylized facts: small open economy, well integrated in European market Member of the NATO and EU since : fastest economic growth in the EU (annual GDP growth > 10% on average) : sharpest economic downturn in the EU (-4.6% in 2008 and -18% in 2009) 2010: signs of stabilization Population – 2.3 mln or 0.5% of EU GDP per capita in PPS: 57% of EU average in 2008 (35% in 1997) Openness of the economy (exp. + imp.): 84% of GDP Share of trade with EU 27: 72% of total foreign trade

After the EU and NATO accession, Latvia was the fastest growing economy in Europe GDP growth, %

However, after double digit growth Latvian economy experienced sharp adjustment. How we got into this situation? Real GDP growth (%) F – BoL forecast

Past growth was fuelled by massive capital inflows after the EU and NATO accession, adding considerably to a build up of excessive demand and real estate bubble Bank of Latvia 1 EUR = LVL Government budget Commercial Banks FDIEU Funds Labour remittances

Excessive demand and overheating pressures added to both a build-up of domestic imbalances … Inflation, %

… As wages significantly outpaced productivity … Wages and productivity, 2000=100

... and to a build-up of external imbalances Current account balance, % of GDP

While monetary policy was tightened well ahead of the overheating gained momentum … Interest rates: BoL and ECB Official reserve requirements: BoL and ECB

… Fiscal policy was insufficiently ambitious; no precautionary savings were made during economic boom General government budget balance, % of GDP

Many suggested devaluation as a way out of the crisis. Why devaluation was not appropriate solution?

Devaluation is not a solution for Latvia  Loss of credibility would result in drastic consequences  Positive effects for exporters are uncertain  No improvement in current account  Many corporates would face negative equity immediately  Court system unable to cope with sharp increase in insolvency cases  No motivation to improve efficiency and productivity

Internal adjustment was the only path to follow  Time bought for structural reforms that smooth adjustment  Improvement of public sector efficiency  More gradual adjustment motivates businesses for productive improvements  Less corporate bankruptcies decrease cost to the economy  Latvian economy is reasonably flexible  Ability to pursue far reaching reforms

At current stage the worst is behind us and the economic activity has already bottomed out Real GDP growth (%) * Flash estimate

Labor costs have decreased boosting competitiveness Compensation per employee (% y-o-y)

Wage-productivity gap has narrowed significantly Real hourly wage and labour productivity per hour (2005 Q1 = 100, seasonally adjusted)

Export has already recovered and expands strongly Y-o-y growth of nominal merchandise exports, %

Export share in manufacturing goes up Share of export (in % of total turnover in particular sector)

Unemployment has decreased first since crisis took off Registered unemployment (%)

Retail trade has also reached the bottom and starts recovering Retail trade turnover, % yoy

Past imbalances have vanished, current account has reached surplus with significant improvement in trade balance F - forecast Balance of Payments (% of GDP)

Calm has been restored in financial market: interest rates down to below pre-crisis level after 2010 budget approval Latvia: money market rates, %

Latvia’s CDS spreads are declining and we are no more risk country number one in Europe CDS spreads, in basis points

Latvia: domestic deposits, mln LVL Depositors’ confidence has returned …

… as well as confidence in national currency Deposits in lats and euro, % y-o-y

Bank of Latvia reserves cover more than 200 percent of the monetary base Million LVL

Fiscal consolidation (2011 budget) will be the centerpiece in restoring confidence and putting economy back on sustainable path General government budget balance (% of GDP, ESA’95)

Meeting fiscal targets would qualify Latvia for Euro introduction in 2014 Measure ment EURO Budget strategy General government consolidated budget (% of GDP)