Here in Latvia the internal devaluation continues and the debate is whether the economy is flexible enough for this experiment. I say perhaps it is, Edward says perhaps it isnâ€™t but one thing is for sure: the Latvian economy is (possibly perversely) indeed flexible.
I would like to illustrate this point with a series of numbers for the extremes that we have witnessed in Latvia so in the following I list a series of macroeconomic variables and the times at which they were at their extremes during the boom and during the current bust. After that I try a little discussion of why the development was so extreme here.
GDP growth â€“ from the biggest increase in the EU to the biggest decline
2006 Q3: +12.7%
2009 Q3: â€“19.1%
Inflation â€“ the highest inflation rate in the EU becomes the biggest rate of deflation in less than two years
2008 V: +17.9%
2010 II: â€“4.2%
Wage growth â€“ again both are extremes also in an EU context
2007 Q3: +32.9%
2009 Q4: â€“12.1%
Unemployment rate (among 15-64 years)
2007 Q4: 5.4%
2010 Q1: 20.7%
Current account (% of GDP) â€“ has anyone ever seen a +40 percentage point turnaround in the current account balance in less than three years?
2006 Q4: â€“27.2%
2009 Q2: +14.2%
Credit growth, households
2003 VIII: +85.8% (an early spike but growth rates in excess of 60% continued for several years)
2010 IV: â€“5.1%
Credit growth, firms
2006 II: +54.7%
2010 III: â€“7.9%
Money supply growth (M2)
2006 X: +43.9%
2009 VIII: â€“12.5%
Closely linked to the three latter sets of statistics one can note that house prices dropped some 53% in 2009, see here p. 6, again the largest decline in the EU, while several years during the boom had recorded increases around 60% y-o-y.
But one variable hasnâ€™t changed and here I am of course thinking of the exchange rate which remains at a parity of 0.702804 LVL/EUR and is managed in a narrow +/â€“1% band. Those who follow Latvia will know, however, that there were great market uncertainties surrounding the peg first in March 2007 then in November 2008 (at the time of the nationalization of Parex Bank) where 10-14 November was the week with the biggest ever intervention by Bank of Latvia, which sold 267.65 mill. EUR. Altogether mid-November â€“ mid-December saw a loss of some 18% of foreign reserves â€“ more details on interventions here. In terms of interest rates the June 2009 scare saw the overnight interbank rate (RIGIBOR) peak at 33% on 26 June.
Latvia is not the only country with a credit boom, with a housing boom or with problems of overheating but one may ask why it was so violent here, why almost all numbers were and are more extreme. I shall try to provide some explanations below.
1. The Latvian credit boom was not just a boom, it was more of an avalanche as it represented the emergence of the financial sector. Whereas loans to individuals and enterprises constituted some 16% of GDP in 2000 this reached 91% of GDP in 2008 X, when loans saw their peak.
2. There was a naÃ¯ve belief in rapid income convergence both among politicians (see this story from the Baltic Times in 2006 where a goal was formulated by Latviaâ€™s First Party to raise Latviaâ€™s standards of living to those of Ireland in ten (!!!!!) yearsâ€¦.). This belief must at least to some extent have been shared by the banks since it can explain why they provided large loans compared to actual income.
3. The belief â€“ or certainly the hope thereof â€“ was strong among ordinary people, too. For decades during Soviet rule most had been denied the possibility of oneâ€™s own flat or car. Thus it is not surprising that when something called a loan appears as a possibility, many took it. One may also call it the result of a financially uneducated people which is not to say that such do not exist elsewhere, just look at the subprime market in the US or Brits (and others) buying summer houses in Bulgaria or Turkey.
4. Latviaâ€™s fiscal policy was highly procyclical during the boom thus exacerbating this boom; major consolidation efforts now act as similar procyclical fiscal policy, this time exacerbating the bust.
5. Too late (2007) Latvia introduced a credit register â€“ there is a story about one person who managed to borrow from no fewer than 25 different banksâ€¦.
6. Latvia has many more banks than Estonia or Lithuania and this perhaps led to more aggressive and less prudent lending to keep up market shares.
7. Some also suggest that due to the attractiveness of Riga and its seaside resort/city Jurmala to people from Russia even more froth was created in the Latvian real estate market.
8. The public economic-political debate was poor in the â€˜fat yearsâ€™ and it was somehow â€˜unpatrioticâ€™ to argue that problems were building up.
9. And, lastly and more speculative, but I could imagine that some of the Swedish and other foreign banks that entered brought with them a perception at the subconscious level of the Latvian market being similar to their home markets in terms of customersâ€™ realism and honesty, features that were not always met. Some customers had unrealistic expectations of their future pay (but can you really blame them when wages were growing in excess of 30% a year?), some were most likely dodgy customers from the outset and the banks were a tad naÃ¯ve. I am speculating but from conversations with bankers I am also sure I am rightâ€¦.
And in the end one may just wonder what the total cost of miscalculations due to an environment of extreme macroeconomic uncertainty has been for individuals, enterprises, banks and the public sector.
To end on a lighter note: At the time of writing the outdoor temperature is +32Â° (90F), which is hot here. Less than half a year ago we had temperatures down to â€“30Â° (â€“22F) so Latvia is not just extreme with respect to economic indicators.
Morten Hansen, Stockholm School of Economics in Riga