Einar Repse: Macroeconomic stability - a crucial precondition for a successful
development
Speech by Mr Einar Repse, Governor of the Bank of Latvia, at the Baltic Business Conference, held in
Riga, on 19 May 2000.
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Ladies and gentlemen!
Today we are living in a world where global economic developments affect individual countries much
more than they did a decade ago. Along with the unprecedented degree of economic integration within
the European Union (EU), we see growth also in international trade and financial transactions in other
parts of the world, all of which provides visible evidence of an ever-expanding globalisation.
Latvia joined in this process after regaining independence in 1991. The sad experience of fifty years as
a part of a closed albeit large economy has convincingly shown Latvia that separation from the rest of
the world through strict economic boundaries is counter-productive and cannot ensure sustainable
economic growth. For historical reasons, Latvia and other countries in Central and Eastern Europe had
to start their integration in the global economy from a disadvantageous position. Becoming actively
involved in international economic affairs is probably the only means by which these countries can
catch up with economically advanced countries in Europe in the coming decades.
When economic borders no longer exist and economic developments in one particular region directly
affect other regions, it is of vital importance that the economic policies of small countries like Latvia
are aimed at securing long-term stability. Being a small, open economy, Latvia cannot entirely avoid
external influences, but sound economic policies help to mitigate the negative economic impact of
external shocks.
From this perspective, Latvia's integration into the EU allows for the simultaneous achievement both
of greater integration in the global economy and sound economic policies. On the one hand, prior to
actual EU membership Latvia has concluded the Europe Agreement with the EU, thus greatly
liberalising its foreign trade regime and completely abandoning any restrictions on international
capital flows. Hence, efforts to become an EU member have enhanced Latvia's progress towards
integration into the world economy.
On the other hand, membership in the EU requires a well-functioning market economy, one which is
able to cope with competitive pressures and market forces within the union, as well as the capacity to
undertake the obligations of membership. Thus, pursuit of EU membership incontestably encourages
the pursuit of economic policies aimed at long-term stability.
With respect to Latvian monetary policy it is fair to say that the principles guiding actions at the Bank
of Latvia are already very close to those employed by the European Central Bank (ECB). The law
singles out price stability as the main monetary policy objective of the Latvian central bank and in its
operational practice, the Bank of Latvia enjoys full independence from the government. Direct
government borrowing from the central bank is also explicitly banned by the law. In pursuing its
monetary policy, the Bank of Latvia uses the same market-based instruments employed by the ECB.
Latvian experience confirms that an independent central bank and firm anti-inflationary policies
produce the good results expected. Annual inflation in Latvia declined to 2.4% in 1999. The lats has
proved its stability for over six years, providing a solid foundation for restructuring and growth in the
Latvian economy. Even without participation in the EU Exchange Rate Mechanism, the lats has stayed
within the +/- 15% band against the ECU and later the euro during this entire period.
Fiscal policy in Latvia has always been implemented with EU accession in mind, thereby, in
accordance with the European Stability and Growth Pact provisions, avoiding unsustainable
government expenditure. Despite the dynamic political environment in Latvia since independence,
every government has declared EU membership its top priority. Therefore, the pursuit of strict fiscal
policies has never been threatened.
Over the past few years, as prudent monetary and fiscal policies led to productive economic
transformation, Latvia has become one of the most successful transition economies in Central and
Eastern Europe. These policies were tested in 1997-1998 during the Southeast Asian and Russian
crises, but the Latvian economy has recovered from these shocks at a relatively fast speed and is now
on a growth path again.
At a time of external pressures, the credibility of national economic policies becomes crucial to
economic performance, as was evident in Latvia over the previous year and a half. In 1998, the current
account deficit in Latvia was financed mainly by long-term capital, as foreign direct investment and
other long-term capital inflows amounted to 72% of all capital flows. As a result, Latvia did not suffer
from a sharp reversal of short-term capital flows that could have damaged the economy. As time went
by and the country's economic situation remained stable, the confidence of foreign investors
rebounded quickly. In the second half of 1999, inflows of foreign direct investments increased by
27%, as compared with the first half of the year.
The confidence in the Latvian banking industry was also restored rather quickly among both foreign
investors and the general public. Presence of foreign capital as a percentage of total bank capital
strengthened and main banking indicators improved considerably. Bank lending increased, acting as
the engine for economic growth. Total loans increased by 52% in 1998 and by 15.3% in 1999, and
95% of all loans have been directed at the private sector. Credit growth has been accompanied by a
gradual shift from short-term trade finance to increased lending directed towards the productive sector
of the economy. In February 2000, the share of loans with a maturity of more than 5 years amounted
to 16.8%, while at the end of 1998 the respective figure was 13%. Increased public confidence in the
banking sector is also indicated by a 6.3% growth in residents' deposits in 1999. Long-term deposits
(over 12 months) grew by 82% in 1999, thus exceeding the pre-Russian crisis level.
Positive trends can be observed in other Latvian financial markets as well. After the share prices fell
during the aftermath of the Russian crisis in 1998, the stock market has rebounded: in January 2000,
the stock market index in Latvia exceeded the 100 mark for the first time since the Russian crisis. In
the first three months of this year, the Dow Jones Riga Stock Exchange Index increased by 33%.
In 2000, the market for government securities has become both wider and deeper, as 3-year
government bonds were successfully launched in the domestic market for the first time in January,
followed by 5-year bonds in March. The share of government bonds with a maturity of 1 year or more
amounts to 86.5% of all government securities. The development of yields on government bonds
issued in international markets also shows increasing confidence in the economic policies of Latvian
authorities. The spreads on 5-year Eurobonds in the secondary market narrowed from 330 basis points
at the beginning of May last year to 148 basis points in February of this year.
A balanced central government budget for 1999 had been adopted originally. Strict fiscal policy
enabled the government to use the budget as an automatic stabiliser in the aftermath of the Russian
crisis and allow the budget deficit to grow up to 4% of GDP in 1999. However, it is important to stress
that this is considered an extraordinary one-time measure. The government has expressed strong
intentions to reduce the deficit to 2% of GDP in 2000, with a balanced budget remaining the target for
2001.
As a result of these policies, all of which received public support, the unemployment rate dropped
from 10.1% in March 1998 to 9% in March this year, and real GDP development after a 3.6% growth
in 1998 remained positive in 1999 as well.
Given the beneficial impact of sound economic policies on Latvia's integration into European markets,
there is little doubt that these policies will be implemented in the future as well. In fact, the provisions
of the European Stability and Growth Pact and requirements for the members of the monetary union
laid down in the EU Treaty specify the direction of economic policy, a direction to which Latvia is
committed. Although these criteria are not legally binding for the country prior to EU membership, in
the opinion of Latvian authorities and the Bank of Latvia the Maastricht criteria are the proper
principles of sound economic policies. Consequently, economic policy in Latvia will be implemented
in a way that facilitates thoroughgoing compliance with these requirements in due course. We strongly
believe that these policies will establish our country as a small but reliable player in world markets and
hence ensure rapid and sustainable growth in Latvia.