Question

SECTION A (50)
Read the case study below and answer the questions.
SHORT RUN STABILIZATION AND LONG RUN COMPETITIVENESS: THE LAVITAN CASE
Growth of a young country
Latvia – a small, young country on the east coast of the Baltic Sea – has recently earned the title of a ‘‘tiger’’. After gaining its independence from the Soviet Union in 1991, the country embarked upon a challenging road of transitioning from a planned to a market economy. The first decade proved to be tough: the beginnings of free market reforms were met by a harsh contraction of the economy, and only in the mid-1990s the country began to grow slowly. Inflation soared, especially in the first years of life of the Latvian Lat (the local currency). A banking crisis struck in 1995 and the country was hit hard by the Russian financial crisis in 1998. The new millennium was thus met with an income per capita level barely one sixth of the level of the rich European countries.
Just as the country entered its second decade of independence, though, things began to look rather optimistic. The economy started growing steadily at 6-8 percent, the budget deficit was massively reduced to desirable levels, and inflation was finally low. External trade was growing steadily and gained ever bigger momentum. The economy began to regain confidence in the banking sector as it received more stringent regulation and supervision. In 2004, Latvia was officially admitted to the European Union along with the other two Baltic States (Estonia and Lithuania) and several other post-Soviet countries. Optimism culminated and growth flourished: pegging the Lat to the Euro in 2005 with prospects of adopting the Euro as the national currency fueled even more confidence and encouraged more trade. The next few years after admission to the EU saw double-digit economic growth, flagging Latvia as the fastest growing economy in Europe. The banking sector, dominated now by Scandinavian banks, unleashed massive lending to businesses and households: the prospects looked good, expectations were high, and consumer confidence was at its peak.
The credit bubble continued to expand and the realization that it was built upon unrealistic expectations for economic growth came too late. The massive lending that took place in a matter of a couple of years increased consumption, yet it did not equally improve the future prospects of production. In late 2007 and in 2008, it became apparent that the economy was overheating.
The fall of the ‘‘Baltic Tiger’’
The fast growth of the economy created significant macroeconomic imbalances. The consumption boom in the country built grounds for the strong growth of imports, which led to a massive current account deficit of a staggering 25 percent of GDP already in 2006 (Hansen, 2010).The overheating housing market was accompanied by imbalance and tensions in the labour market as well. The demand for labour in the booming economy was high, yet the supply was decreasing due to large-scale emigration after joining the EU in 2004. Thanks to such pressure, Latvia hit another record number for the EU: an annual wage increase up to 30 percent. The wage growth by far exceeded productivity growth, forcing companies to increase prices, leading to 17.9 percent y-o-y price inflation in May 2008.
As a consequence, Latvia’s currency sharply appreciated, sending worrying signals about the decreasing competitiveness of the country (Hansen, 2010). These large macroeconomic imbalances, worries about sustainability of credit growth rates, inflation, property price bubble as well as the high risk of deterioration in the quality of loan portfolio motivated Scandinavian banks to finally tighten the lending standards (Klyviene and Rasmussen, 2010). Once the credit from the Nordic countries froze and housing prices started to fall, construction and retail sectors stagnated. Pessimism replaced unwarranted optimism, negatively impacting consumption and suppressing the entire economic activity (Hansen, 2010).

The ‘‘Baltic Tiger’’ crashed, and it crashed hard. The most rapidly developing economy among the EU countries, experiencing a double-digit growth of 12.2 percent in 2006, was shaken by the steepest GDP contraction of 18 percent in 2009.Unemployment peaked at 20.7 percent, consumption dropped by 22.4 percent and gross fixed capital investments plunged by 37.7 percent.
In December of 2008, the IMF provided a e1.68 billion rescue package to help Latvia fill in the gapping hole in its budget deficit and calm its capital markets. Even though the injection may have convinced the markets for a while, in June 2009 the Central Bank of Latvia had to sell almost e1 billion in exchange of Lats in order to defend the currency.
Is the government to blame?
Even though before the accession to the EU Latvia was undergoing a period of intensive reforms, due to successful growth of the economy the policy makers lost the urgency to reform as everything already seemed to be heading in the right direction (Erixon, 2010). Due to the currency’s peg to Euro, the monetary policy in Latvia was restricted; hence the supply of credit was out of control. Therefore, only fiscal policy tools could be used to regulate the economy. It seemed, however, that instead of using this tool wisely the government further fuelled overheating through massive public spending (Klyviene and Rasmussen, 2010).
Tax revenues were growing as the economy expanded. Instead of following the standard counter cyclical fiscal policy in a time of favourable macroeconomic environment and decreasing fiscal expenditure in order to accumulate a budget surplus, Latvia chose to follow a pro-cyclical fiscal policy (Hansen, 2010). Government spending relative to GDP increased from 35.6 to 37.7 percent over 2005-2007 (Karlsson, 2009). Not surprisingly, such pro-cyclical fiscal policy increased the demand for credit, consumption and supported the biggest boom in the EU. Excessive government spending did not allow accumulating a budget surplus which could serve as a buffer in times of crisis.
In 2007 the Latvian government adopted a ‘‘Stabilization plan’’ aimed at developing the budget surplus, reviewing effectiveness of government spending and implementing reforms necessary for increasing long run productivity and competitiveness (Gerhards, 2008). The plan came too late. By 2009 even the Latvian president Valdis Zatlers was questioning the appropriateness of the actions taken and the fate of the country: ‘‘We had no political will, we lacked economic and entrepreneurial foresight, the government was pathetic. Now we face the existential question: will Latvia survive?’’ (Hansen, 2009).
Policy decisions today
A. Should the Lat be devalued. . .
For countries with a fixed exchange rate regime, devaluation is roughly the only monetary policy tool that can be considered for targeting economic stability. A deliberate devaluation of the Lat would make the currency cheaper. Consequently, imports would become more expensive and exports to other countries – cheaper, thus reducing the trade deficit. By the end of 2009, the international community was voicing a strong opinion that Latvia should devalue. For some economists (including Professor Paul Krugman) it looks like a case of Argentina: a fixed exchange rate, an excessive current account deficit, substantial foreign bank lending, and a burst of an overheated economy. They believe that there is no other way for Latvia to regain competitiveness without a devaluation.
Devaluation, however, might turn out to be very costly and may not be as effective as intended. During the credit boom, Scandinavian banks provided cheap capital with considerably lower interest rates for loans denominated in Euro as compared to loans in Lat. As a consequence, in 2008 around 70 percent of bank deposits and nearly 90 percent of loans were issued in Euro. Devaluation of the Lat would thus pose a serious risk of insolvency.
B. . . .or should Latvia take the ‘‘hard road’’ instead?

As an alternative to external devaluation, Latvian politicians have started to talk about an ‘‘internal devaluation’’: keeping the currency fixed to Euro, but undergoing structural reforms to improve productivity and public sector efficiency, and reducing wages. While currency devaluation can happen overnight, internal devaluation may take months or years of structural reform and may lead to public unrest.
As a matter of fact, the government started to introduce austerity measures already in 2007 12 percent (or 115) state schools were closed, because budget financing was shifted from inputs-based (number of teachers) to output-based (number of students). In 2008 the government abolished half of state agencies, which reduced the number of civil servants by 30 percent. In October 2009, the government slashed budget deficits to meet targets imposed by the European Union for an additional e7.5 billion support package. About 75 percent of the expenditure cuts were thus done in 2009, bringing some positive hopes that austerity measures were carried in time.
Internal devaluation, however, does not receive much public support on the international level. The experience of Argentina seems too painful: the society was making one sacrifice after another and was slowly tortured by never ending public spending cuts and rising unemployment. The country suffered a break-through of riots and violence, consequently forcing itself into devaluation of the local currency.
Moreover, in case of a successful internal devaluation, the economy may be pushed into a vicious cycle of deflation, yet having no option to increase money supply through monetary policy decisions. Keeping the exchange rate fixed and facing a deflationary cycle would be extremely hard to cure. Internal devaluation thus requires a well thought-through policy and strong political will.
Thoughts on long run strategy: global competiveness is at halt
As if instability due to macroeconomic imbalances were not enough, the competitiveness of Latvia in the global arena looks gloomy as well. As of 2010, the Soviet Union heritage is still deeply embedded in the economy. Although many may be happy about the progress the country has made since the regaining of independence, there are many cracks in the foundations. Right after the break down of the Soviet Union, national assets where privatized by businesses (in most cases backed-up by foreign capital), which usually used illegal practices and only later became legitimate. The country still has not imposed a significant property tax or progressive taxation, because the bargaining power of oligarchy has been strong and the level of corruption has decreased only marginally. Labour unions are just a nice expression, implying little (if not nothing) when it comes to wage setting. Hence, companies can cut wages rather freely. Finally, there are only a few politicians who understand economic market forces. Many of them have lived their lives under planned economy and have little idea how the economy should be run under free market rules.
In 2009, Latvia ranked as the 29 out of 183 countries according to the ease of doing business criteria (‘‘Doing business’’, The World Bank, 2010), which was three positions lower as compared to 2008. The ranking indicates that the business environment in general is favourable and above the world average. Yet, Latvia still needs to address several issues if it wants to join the ranks of the rich. In particular, according to World Bank (2010), legislation relating to investor protection, construction permits and employment procedures seems to be of particular concern.
The Enterprise Perception Survey 2009 has pointed out that the top constraints to investments in Latvia are tax rates, political instability, tax administration, access to finance, informal sector and inadequately educated workforce (‘‘Business environment’’, The World Bank, 2011).

In addition, in 2009 Latvia ranked 45 out of 179 countries according to the economic freedom index acknowledging the country’s openness to foreign trade and the efficiency of entrepreneurship regulations. Latvia is still perceived as a rather corrupt country. In 2009, it placed the 69 position out of 203 in the world’s Control of Corruption Indicator of the World Bank Group. In addition, the country’s judicial system is relatively inefficient and subject to long delays, and enforcement of intellectual property protection laws is weak. These factors pose challenges to Latvia’s economic freedom and long run competitiveness (‘‘Latvia’’, Heritage, 2011).
Adapted from Vala, M; Drasutyte, K; Mazulyte, E and Daunys, L (2012), Short Run Stabilization and Long Run Competitiveness: Latvian Case, Emerald Emerging Market Case Studies
QUESTION 1 (25)
One of the main macroeconomic objectives of any country in the World is economic growth as measured by the gross domestic product (GDP) per capita from one year to the other. However, the fast growth rate of the Latvia economy created significant macroeconomic imbalances.
1.1 Discuss the costs and benefits for Latvia following the transitioning from a planned to a market economy.
(10)
1.2 Critically evaluate the economic imbalances that Latvia economy experienced and recommend the policy options that could have been adopted in order to manage each of them. (15)
QUESTION 2 (25)
Assume you have been appointed as the Prime Minister of Latvia and you understand that there is much to handle to stabilize the economy and restore competitiveness, which has deteriorated significantly over the last decade. Unfortunately, you have no time to evaluate future prospects of the country – after the weekly board meeting you have received a formal request from your advisors that Latvia should carry out currency devaluation or an internal devaluation.
2.1 Critically evaluate the type of devaluation Latvia should carry out and recommend the policy options that could be adopted in order to ensure a successful development path for Latvia in the long run. (10)
2.2 Evaluate the critical constraints to investments in Latvia and highlight how they pose as challenges to Latvia’s economic freedom and long run competitiveness. (15)

Answer 1

1. In a planned economy, investment, production and other distribution related decisions are being taken based on economic plans and production plans. On the other hand, the decisions of investment, production and distribution in a market economy are being taken based on supply and demand related factors. As transitioning from planned to market economy, Latvia could save costs involved in overproduction and underproduction as the production takes place based on supply and demand. Moreover, as the demand in Latvia increases, due to probable tax cuts, high flow of money supply , the suppliers were not able to fulfill the demand and as a result, there arose a mismatch of demand and supply. It had resulted in increasing the prices and inflation and at the same high level of imports which had affected the economy negatively.

2. There was a high level of supply and demand mismatch leading to increased prices and high level of imports. This had happened due to tax cuts by the government and increased government spending leading to high level of consumption. Government should have made use of monetary and fiscal policy tools like increase in CRR and Repo Rate to bring down the consumer's consumption and demand. They should have raised the tax rates and thus reducing the disposable income in the hands of the consumers.

3. Latvia should devaluate the currency in order to promote exports. Moreover, the disposable income of the consumers should be reduced by increasing the tax rate, increasing the CRR and Repo Rate thus reducing the consumption level of the individuals.

4. Constraints to investments in Latvia:

Government doesnt support the investments much.

Labor cost is high

Stringent legislation related to investor protection, construction permits and employment procedures are not favorable for possible foreign investments.

As a result, the foreign firms are not interested in investments in Latvia, leading to lower economic development of the economy.