Question

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).

please help with a detailed, fully explained answer for Question 2. thank you

Answer 1

Solution 2.1

Latvian government needs to pursue smooth to moderate devaluation of 5 to 10 percent range which revives exports and thus forex reserves grow exponentially lowering furrent account deficits and also leading to currency stabilisation. The forex kitty thus helps stability when excessive depreciation or appreciation takes place. Moreover to revive economic growth with fiscal policy tools at helm, the government has to make structural reforms than cyclical reforms. Here each downgraded sectir needs to be revived using liquidity injection, tax credits and ease of doing business. Moreover government needs to adopt external commercial borrowing to fund these projects and debt refinancing of existing loans to adhere to fiscal discipline and same time disinvestment of public sector companies in virtue of achieving budget surpluses.

Solution 2.2

The above revival methodology proposed confronts bottlenecks and headwinds like global uncertainty, lack of Monetary policy congruency which navigates economy in similar direction, lack of easy availability of foreign loans at cheaper interest rates due to low sovereignty rating of Lavian economic growth.

Moreover, challenging times like implementation lag and high tax rebates will cause breach of fiscal deficit and create budget deficits as taxes are usually evaded in recession and slowdowns and thus the revenue targets may get a miss creating catch 22 situation where it xan lead to stagflation as well.

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