During the IMF-EU programme some have expressed concern about Latvia’s ability to repay the loan.
That is actually not a serious problem – it is one of the places where a country has a huge advantage over a mere mortal soul.
Government debt is often measured as a share of GDP (see Figure 1). This makes sense since GDP can be seen as a country’s tax base i.e. the amount of money from which it can tax. Latvia’s tax take was 35% of GDP in 2010, a relatively low share by EU standards.
The dynamics of the debt ratio are not that complicated but they are affected by five factors.
A higher budget deficit by itself adds to the debt ratio. Higher interest rates on government debt add to the ratio. Economic growth reduces the ratio (since it widens the tax base). Higher inflation does the same since it widens the tax base in terms of lats. Lastly, the higher the existing debt ratio, the higher is the effect from interest rates, inflation and growth.
The exact relationship is provided at the end for those who might be interested.
As is seen from Figure 1 Latvia’s debt ratio declined between 2004 and 2007. This wasn’t due to budget surpluses, however, but was strongly affected by a huge expansion in the tax base in terms of both economic growth and inflation. As can be seen from Figure 2, the budget (at least the so-called primary balance which means the budget before interest payments on debt) was roughly in balance in those years (but should of course have been in a major surplus to reflect the overheating economy and the windfall tax revenues at that time).
With the recession where tax revenue falls off the cliff (people become unemployed and pay less income tax, buy fewer goods and pay less VAT etc.) the budget went into major deficits, which are now slowly and as part of the IMF-EU agreement being reined in.
In terms of debt sustainability there is one reason but, crucially, coming from two sources for this austerity. If budget deficits were allowed to remain out of whack this would by itself raise the debt ratio but if financial markets would start seeing Latvia as a Greece-in-the-making, interest rates on Latvian debt would shoot up, making it much more expensive to refinance the debt and also adding to the debt-to-GDP ratio. This, as can be seen with Greece, can easily lead to a self-reinforcing downwards spiral.
It is thus of no surprise to readers of my column that I very much support the austerity efforts. Diminished budget deficits calm financial markets and allow for lower interest rates as the risk of default remains low. Latvia sold USD denominated 10-year bonds in June this year at 5.491%, a rate way below the ones in Greece, Ireland, Portugal etc.
The added benefits of maintaining a low debt ratio is fulfilling the Maastricht criterion on debt (max 60%) and preparing for the future when fiscal policy will be strained by poor demographics.
I thus don’t understand it when Riga mayor Nils Ušakovs, according to BNS 28 July, suggests postponement of repayment to the IMF-EU. If, which is very likely, financial markets view this negatively it is interest rates up and a higher debt burden. Not what Latvia needs and no need to jeopardize euro entry either.
Morten Hansen is Head of Economics Department, Stockholm School of Economics in Riga
And here the exact formula for the dynamics of the debt-to-GDP ratio:
D = debt-to-GDP ratio dD = change in the debt-to-GDP ratio i = nominal interest rate on debt p = inflation rate y = growth rate of GDP bb = primary budget balance
dD = Dx(i – p – y) – bb
Use e.g. a debt-to-GDP ratio of 50% (0.50 in the formula), a 5.5% interest rate (0.055), 3% inflation, 4% economic growth – not unreasonable and certainly not wildly optimistic for the nearest future. Then the government can run a primary budget deficit of e.g. 0.5% and still see the debt burden reduced:
dD = 0.50x(0.055 – 0.03 – 0.04) – (- 0.005) = – 0.025
This is where it is good to be a country that lives (hopefully) forever. You can in principle run budget deficits forever but always have accumulated debt at a sustainable level.
You can also have fun entering Greek numbers such as D = 1.50, i = 0.20, bb = -0.05, y = – 0.04 or so and see why their debt is NOT sustainable….