Ilmārs Rimšēvičs: Structural reforms to pave the way to prosperity in the
future
Speech by Mr Ilmārs Rimšēvičs, Governor of the Bank of Latvia, at the Baltic Economic
Forum 2010, Riga, 23 September 2010.
* * *
Ladies and gentlemen!
I think only very few would have missed out that the Baltics have attracted a lot of
international attention during the recent years. I would even venture to say that the three
small countries located by the Baltic Sea - and Latvia above all - have stretched out their
boundaries considerably to occupy an increasingly large part of the globe: they have
suddenly become more noticeable than ever before. Obviously there must be something
unique about these countries that has made them stand out during the recent crisis.
It might be the flexibility of the Baltic tigers: they have shown themselves capable of making
great leaps in both directions - forward and backward. The real uniqueness obviously lies in
the way the economies have adjusted to the crisis and the magnitude of the economic swings
they have experienced. Just a few short years ago we were amongst the strongest
performers in the entire world and clearly the fastest growing economies within the EU. With
Latvia leading the race, its GDP grew in the double digits on average for four consecutive
years after the EU accession. Other Baltic neighbours followed suite. Blown up by the massive
inflows of foreign funds and breathtaking lending growth, by the expansionary fiscal policy and
remittances or repatriated wages - domestic demand ballooned bringing along an accelerating
inflation and a widening current account deficit. Latvia was unique in recording a current
account deficit as high as 27% of GDP during the peak quarters, and stunned the world by
sustaining it above 20% for two years in a row. Inflation peaked at 18%, and real estate prices
more than doubled in just a few years. Similar, but somewhat less extreme developments were
observed in Lithuania and Estonia, with both inflation and current account deficits staying in the
double digits during the boom years.
The booming economies rewarded their citizens with generous income flows. Labour
markets soon became caught in a vice between massive demand pressures and limited
supply of workers that was significantly constrained by labour outflows after the EU
accession. This gave the rise to uncontrolled wage developments that by far outstripped
productivity. Conventional wisdom told us this was leading to dead end. However, the
temptation to reach the prosperity of Western Europe overnight prevailed, and the
vicious circle of wages and prices kept tightening. Economies kept going and wage increases
of 20-30% a year became a fact of life. In Latvia, salaries more than doubled between 2004
and 2008 opening a wide wage-productivity gap. Similar developments were recorded in
Estonia, and somewhat less pronounced but still significant departure of wages from
productivity was observed in Lithuania. Consequently all three countries suffered from a
significant deterioration of cost competitiveness.
All these developments weakened the economies and made them extremely vulnerable to
sudden changes in investor sentiment and global woes. Initially it seemed that the Baltic
countries were easing into a soft landing. This was supported by banks cutting lending in a
controlled way at the outset of the global financial crisis. However, the collapse of Lehman
Brothers uncovered the real weaknesses - flushing away most of the wealth created in an
unsustainable way. Throughout 2009, GDP fell by close to 14% in Estonia and Lithuania, and
by an even more shattering 18% in Latvia.
to support economy and to solve old
Many suggested devaluation as the best solution
problems. However, that was clearly not an option for the Baltic countries given their
openness, flexibility, large foreign-currency-denominated debt and long history of fixed
exchange rate regimes serving as an anchor for macroeconomic stability for the Baltic
States, and also Bulgaria. Already now Baltic performance has reassured many sceptics that
the internal adjustment strategy simply works, making a good case for other countries
to move forward with fiscal consolidation and much needed reforms. I mentioned the internal
adjustment strategy - there was actually such strategy: the State Treasury was running out
of funds and there is simply no other alternative.
The reform agenda in the Baltics has been ambitious. To ensure fiscal sustainability, the
adjustment burden undertaken ranged from an estimated 9-10% of GDP in Lithuania and
Estonia to 14% of GDP in Latvia throughout 2009-2010 - something that the world had not
seen before. And yet we did not get stuck in a protracted recession as sceptics
predicted. We have already reached a significant progress in regaining cost competitiveness,
have made our economies structurally more resilient and are moving towards sustainable
growth.
So far I have addressed the Baltics as a region rather than the individual economies that they
are and therefore it might seem that developments there were rather similar. Despite the
many similarities, however, there were also significant differences that are extremely
important if one is to draw lessons from the recent crisis. One may also say that while all
three being tigers - a metaphor commonly used to describe the past exceptionally strong
expansion of the Baltic economies - each of the three had and still has its own - unique -
character.
One of the obvious differences among the Baltic countries was their policy stance in the
runup to crisis. among the three countries throughout
Fiscal discipline differed considerably
the boom years that largely shaped their performance during the crisis.
on the fiscal front. Experiencing the
Latvia was clearly the most quick-tempered one
fastest economic expansion and extremely strong cyclical upturn in tax revenue, we still
managed to spend more than we earned and recorded a budget deficit every single year
during the boom. While being rather moderate in nominal terms, the deficits were extremely
large when cyclically adjusted - amounting to 7-8% of GDP, in turn adding extra fuel to the
already severely overheated economy. Budgetary discipline was extremely weak. Every
single year when revenue performance turned out better than expected, budget laws were
amended to further boost expenditure. Between 2004 and 2008, expenditure picked up
21⁄2 times, and most of that was of a structural nature. As many of you know - there was
really one industry which was overheating - namely construction and nothing was done to
prevent it. This meant an accumulation of an enormous fiscal gap - over 20% of GDP -
that was temporarily obscured by the economic boom but became obvious with the burst of
the bubble. As authorities rapidly ran out of available liquidity and no investors were ready to
finance the massive fiscal needs, Latvia had to turn for international support, becoming a
program country under the IMF Stand-By Arrangement and European Commission support.
Lithuania was not materially better in terms of fiscal management, but was lucky to lag
behind in terms of the economic cycle, which resulted in a less overheated economy before
the crisis took off. in pursuing
Estonia, however, showed much more prudence
countercyclical policies accumulating considerable liquidity cushion to support economy during the
downturn. Every single year since 2002 Estonia ran budget surpluses that increased over
time as the economy accelerated. This made a significant difference in the way economies
adjusted during the crisis with strong implications to their future growth prospects. While
Latvia and Lithuania ended up with skyrocketing public debts, Estonia's debt remained
contained, allowing for a greater fiscal space and stronger growth potential in future. Already
now Estonia has a faster GDP growth and its future looks much brighter. In other words - it
is the combination of prudent fiscal and monetary policies which is behind the most notable
difference with the other Baltic States. A by-product of Estonia's persistent prudent policies
or - should we say - a prize for its very top stands during last 10 years, that is also going to
be its membership of the Euro area as early as 2011.
The euro is not a solution to all problems and it does not mean a automatic welfare gains for
converging economies like ours, but if policies are kept on track, the euro helps boosting
growth potential and provides vast opportunities for future development. While we have
been struggling to simply stay afloat, Estonia has strategically moved towards its aim of
joining the euro. I can only express a friendly envy regarding their pragmatism, strategic
mindset and ability to move in unison to make use of synergies and reach common
targets. "Yes We Can!" sounds like Estonia, and I would like to wish every success to the
Estonian authorities in their future endeavours of making their country a better place to live
and advance.
Our northern neighbour is a good example that
What can we learn from Estonia? any
target can be reached, but this requires strategy and ambition. Latvia has shown that it
can brace up and make hard but necessary steps forward when cornered. However, all
determination tends to fade away with the situation becoming less pressing.
When afloat we
start drifting downstream instead of heading towards the river bank. I am afraid, as we
hear, that Latvia has done a good job, that we are leaving the crisis behind us, there could be
less motivation to continue the adjustment.
Hopefully, this has been changed by the recent crisis. Latvia is gradually heeling its
economic wounds and, hopefully, has learned the lesson that a county cannot live beyond its
means without endangering its future prospects. To create a stable economy, which
generates more prosperity, is clearly the target for the undertaken reform agenda in this
country. In any case, we need another round of fiscal consolidation and structural
reforms to bring public finance on a sustainable footing and economy back on a sustainable
growth track. At the moment, unsustainable public finance is significantly hampering lending
activity, investment, economic activity and new jobs, reduction of the state debt. In other
words - deficit can hamper future growth should this problem remain unsolved.
While the economic and financial situation in Latvia has improved significantly since the
onset of the recent crisis, we are not out of the woods yet. According to our estimates
another 400 million in expenditure cuts backed by structural reforms that make them
to bring the recently high budget deficit towards a more comfortable
permanent are needed
level in 2011. The resulting budget deficit of 6% is not a magic number, though!
Circumstances permitting, the deficit could be even smaller, provided Latvia with higher
rating, lower interest rates, new investments and new jobs. This would also bring us much
closer to the euro introduction in 2014 as an exit from the international support program. I am
perfectly aware that this is not an easy task; however, it is realistic should we have a
strategic mindset and enough ambition.
In conclusion let me quote the Estonian president Toomas Hendrik Ilvess from what he said
back in April 2009 during a meeting with his Latvian counterpart Valdis Zatlers:
"In Estonia we know that tax revenue is lower than expected and additional steps are
required. (..) At times when money runs out, there are no simple or pleasant solutions
left - expenditures have to be cut. It is an illusion to think that we will be able to spend
money, which we actually do not have. That is impossible - for individuals and states alike.
Therefore - if one does not have the money to spend, expenditures have to be cut. The
question then naturally is - where to cut.
I believe that both Estonia and Latvia are clearly
aware that it is fiscally responsible to make these complicated choices now and not
dump these complicated choices on the future generations.
Thank you for your attention!