# **3.13 Growth Scenario in the Long Term**

Empirical research has highlighted the role of the income gap and the level of education in the convergence process. Using a methodology developed by Benhabib and Spiegel (1994) and already used by Doyle et al. (2001) for a panel of transition economies, we can estimate Latvia’s TFP growth rate for the next decade. At the steady state, Latvia’s capital output ratio will remain constant. As a result, per capita GDP growth at the steady state will be TFP growth over the labor share plus changes in the quality of the labor force. Projected TFP growth is presented in Table 2 below.

||**Table 2: Projected T**<br>|**FP Growth Rates f**<br>|**or the Baltic Countries**<br>|<br>|
|---|---|---|---|---|
||**Average years of**<br>**schooling**|**Gap with US**|**Projected TFP growth**|**Labor force growth**<br>**_1999-2010 average_**|
|Lithuania|12|4.6|4.2|0.2|
|**Latvia**|**12**|**4.6**|**4.5**|**-0.4 **|
|Estonia|13|3.2|3.4|-0.2|
|Poland|9.5|3.8|3.0|0.2|

Sources: Calculations using the equation from Benhabib and Spiegel (1994), which is: [. _0007*Schooling*Gap + .0014*Gap_ ]. <u>Gap</u> is the ratio of the US per capita GDP to that of the country concerned in 2000 at current international prices from the World Bank Development Indicators. Labor force growth is average annual growth rate over 1999-2010 calculated from World Bank Development Indicators. Data for Poland is from Doyle et al. (2001).

These projections indicate that Latvia has the potential for rapid growth but convergence with EU income levels will probably take time to materialize. An important caveat to bear in mind, however, is that the projections are based on an assumption of a constant capital-output ratio. The realism of this assumption is questionable given uncertainties about the viability of capital stock inherited by Latvia from the former Soviet Union. The pace of convergence with Western European countries would clearly be influenced by any substantial change in the capital-output ratio. This has major policy implications for the medium term, as the Latvian authorities will need to ensure adequate investment ratios, stimulate domestic and foreign savings to fund the necessary investment, and implement measures to create the legal and business environment that will be most conducive to TFP-intensive growth.

# **3.2 Why Labor Market Issues are Key to Latvia’s Convergence with the EU**

The potential benefits for Latvia when it adopts the euro are well known: the single currency will reduce transaction costs with agents in EMU countries, and hence raise the static efficiency of the economy. It will eliminate exchange rate risks as well as the cost of hedging and currency exchange. The resulting improvement in transparency will increase the intensity of competition in goods and factor markets, thus raising the dynamic efficiency of the economy. This in turn should foster innovation, trade, investment, and growth, thereby improving employment prospects.

The downside will be the heightened labor market risks for Latvia. In theory, the exchange rate constitutes a useful tool for macroeconomic adjustment in the case of asymmetric shocks. Exogenous shocks that hit countries asymmetrically require a response of real exchange rates between the countries concerned in order to adjust relative wages between them. This is usually done through adjustment of nominal exchange rates or adjustment of nominal goods and factor prices in one country relative to another—so that higher unemployment is mitigated. This is not an option in Latvia where monetary policy is similar to a currency board arrangement. Nor will it be an option when Latvia formally gives up any 14