Latvia is, together with Estonia, Lithuania, Denmark, Austria, Luxembourg, the Czech Republic and Slovakia, member of a rather exclusive club of EU countries that are neither being monitored due to macroeconomic imbalances, nor due to being in an Excessive Deficits Procedure.
Very fine, not least given the IMF and EU programme from which it exited in 2012 and certainly worth keeping that way. The Latvian economy does indeed not display any serious short run imbalances right now but there are still a few areas worth watching. One of them could be external competitiveness, i.e. the development in prices or costs of production here in Latvia compared to similar developments in trading partner countries; that is what the Real Effective Exchange Rate REER) does – an increase in this measure implies Latvian prices/costs running faster than abroad and thus a loss of competitiveness that makes it troublesome to be an exporter.
Figure 1 below looks at this by trying to compare the time before the financial crisis with the time after. I have chosen 2004 (when Latvia joined the EU) and 2010 (when the Latvian economy started growing again after the financial crisis). I then have data for some 20 quarters after each starting point.
As the graph shows – and what I guess everyone would agree with – the two periods are fundamentally different. Leading up to the financial crisis Latvia lost competitiveness on a large scale; the impact since 2010 has been somewhere between minimal and non-existent.
Figure 1: REER for Latvia from Q1 2004 and Q1 2010. First axis: Number of quarters since start of the period
Source: Eurostat and own calculations
But going a bit deeper there is still room for, if not concern, then vigilance. Figure 2 looks at the same competitiveness measure from 2010 but this time with some comparator countries – the Eurozone of 18 countries (still no data with Lithuania included), Germany (important trading partner and well-known competitiveness machine) and Greece (where internal devaluation takes place at a quite remarkable rate).
Figure 2: REER for Eurozone-18, Germany, Greece and Latvia, 2010 = 100
Source: Eurostat
The data says that Latvia has lost competitiveness vis-à-vis Greece but that hardly matters – Greece is unimportant in terms of Latvian exports and imports and thus for Latvian external competitiveness. But it has also lost out, albeit slightly, to Germany and to the Eurozone as a whole. Yep, ‘slightly’ is the word but it might be smart addressing this now instead of waiting until it might be too late for easy reversal as in 2007. Measures to promote competitiveness are difficult to implement and take quite a bit of time to work.
But it would be nice now with the EU Presidency soon over to have more focus on the domestic economy again. Raising productivity and labour market participation should be on the table.
Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council of Latvia
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