Loss of Latvian competitiveness?

Much of the debate surrounding the crises in the PIIGS-countries (Portugal, Ireland, Italy, Greece, Spain) is about their gradual loss of competitiveness vis-à-vis the lean, mean German exporting machine.

If you have followed this debate you might have encountered a graph similar to Figure 1. It displays competitiveness developments measured via the development of the Real Effective Exchange Rate (REER) in these countries using unit labour costs (ULC). (At the very end of this post I have a more detailed description of how to read the graph for those not so familiar with it).

The familiar story is that by keeping a lid on wages Germany has gained, slowly but significantly, in cost competitiveness vis-à-vis the PIIGS where cost control was never that disciplined.

Source: Eurostat (look for exchange rates)

Given that the PIIGS have the euro and thus cannot devalue to raise their competitiveness they must do so via an ‘internal devaluation’, just as has been done here in Latvia and much of the debate centres around whether these PIIGS countries really can do so.

Now look at the same graph but with Latvia included:

Ouch! If the PIIGS lost competitiveness then Latvia must have done so on a grand scale (REER increasing almost a 100% from 2004-08) and this has been at the heart of the devaluation debate.

There is no doubt that Latvia did lose competitiveness. A textbook example of loss of competitiveness was the demise of Amber Furniture, one of Latvia’s largest furniture companies in June 2007. 90+% of its production was for exports and given its type of business it was in serious competition with furniture makers elsewhere. Due to the massive wage increases at the time its ULC increased rapidly. Due to competition with other companies elsewhere where costs were not rising that much it was impossible for Amber Furniture to raise prices to compensate for higher costs. Costs up, prices flat → profits vanish, leading to bankruptcy. I have always wondered why that case, as obvious as it was, did not lead to more discussion about loss of Latvian competitiveness. Then again, that was the time of hush-hush concerning competitiveness and the exchange rate, of course…

But how much competitiveness was really lost? And although the ‘internal devaluation’ here has obviously recouped some of the competitiveness, is it enough?

In their recent book, “How Latvia Came through the Financial Crisis“, Anders Aaslund of the Peterson Institute and Valdis Dombrovskis, Prime Minister of Latvia argue that the crisis is Latvia was not so much due to a loss of competitiveness as a sudden stop of the credit boom and they have a point although they are somewhat self-congratulatory in their description of the internal devaluation as a success story.

Take a look at Latvian exports in Figure 3. Exports kept rising through the ‘fat years’ although competitiveness was constantly sliding. The decline in 2008-09 is a result of the world recession with lower demand from all countries and anyway came when REER started falling again.

Source: Central Statistical Bureau of Latvia

Does the graph not ‘cheat’, one may ask, given that all demand components (consumption, investment, public spending and exports) of the economy were rising in the ‘fat years’?

Not really. Figure 4 shows exports as a share of GDP. This was reasonably stable until 2004, then it increased until 2006 (I would consider that an effect of joining the EU), then it declined again, possibly due to a loss of competitiveness, but not to levels lower than pre-EU membership. And then it has been shooting up because it easily outperforms domestic demand right now; in fact it is the only thing creating positive growth in the economy at the moment.

 Source: Central Statistical Bureau of Latvia

I know that some will disagree but the numbers don’t seem to suggest that Latvia has a competitiveness problem – and one should start with the numbers.

The loss of competitiveness during the ‘fat years’, being much stronger than in the PIIGS countries did not imply a decline in exports, leading me to suggest that the lat was simply undervalued in the early parts of this millennium.

Why didn’t exports soar if the lat was undervalued? My take on this is that exports were profitable but construction and real estate even more so. Both sectors expanded, helping the economy to grow, until there was no more labour available – remember, unemployment dipped as low as 5.4%, way below its equilibrium rate.

But the debate for or against devaluation is most likely not over and a couple of points still not resolved are:

1. Would an external devaluation have shortened the length of the recession?

2. Would an external devaluation have implied a smaller accumulated loss of GDP?

3. Would an external devaluation have had a smaller impact on migration?

Still much to think about…..

Morten Hansen is Head of Economics Department, Stockholm School of Economics in Riga

 

* How to read the Real Effective Exchange Rate (REER) graphs:

Unit labour costs (ULC) measure labour costs (mostly wages) per unit or production. Say, for instance, wages increase 10% while productivity (production per person) is up 7%. Then the cost per unit produced is up by 3% – ULC grows since wages have grown faster than productivity.

The REER graph for e.g. Latvia shows the development in ULC for Latvia divided by the weighted ULC developments, adjusted for exchange rate changes, in its 36 biggest trading partners. An increase in REER thus shows that ULC were rising faster in Latvia than abroad and this higher cost of production can be translated into a loss of competitiveness: Your goods are produced at too high costs. The 2005-08 surge in Latvian REER is mostly due to the wage explosion of those days with wage increases by far outstripping productivity growth and some of it is due to currency depreciation in e.g. Sweden and the UK. The decline after 2008 in REER, i.e. the increased competitiveness is due the declining wages in Latvia. The increased competitiveness 2002-04 is mostly attributed to wages following or even lagging behind productivity growth plus the fact that the lat depreciated against the euro at that time (when the lat was fixed to the IMF currency SDR).