Latvia: Tough times ahead but the country looks fiscally well-prepared

Ever more draconian measures are taken to contain the virus and the economic fallout is increasing by the day, if not by the hour. The breakdown of supply chains is a negative supply shock to the economy while the lack of access to travel, restaurants, movie theaters etc etc is a massive negative demand shock. Both shocks reduce GDP and increase unemployment and very rapidly so.

The Latvian government is reacting swiftly with targeted measures towards health care, businesses in the worst affected parts of the economy (for instance travel but the list gets longer by the day), social assistance etc. All very much needed to create a bridge between today’s calamities and a (hopefully) not too distant future where the worst from this pandemic is over or at least contained. No need to see otherwise healthy firms collapse due to relatively short-term (we hope…) trouble, however massive.

But it will cost and it will cost a lot. Given the numbers, however, Latvia should be in a reasonably good position to provide such assistance. A comparison of some numbers with the rest of the EU and with Italy in particular should bring home that point.

In terms of fiscal policy, Latvia, with a small budget deficit, see Figure 1, is well-positioned to let that swing into a larger deficit. This would happen even without emergency measures since tax revenue is set to drop now due to much less economic activity. Latvia would of course have been even better positioned, had it been in a budget surplus situation, which I would have found appropriate, given the somewhat overheated labour market of just a few weeks ago.

Figure 1: Government budget balance 2019 (estimate), % of GDP, EU28

Source: IMF

Latvia will need to borrow but financial markets should not be spooked by this as long as the government measures to support the economy are seen as well-targeted and temporary. Latvia has relatively low public debt and can quite easily let this grow several percentage points, see Figure 2.

Figure 2: Government gross debt, 2019 (estimate), % of GDP, EU28

Source: IMF

And financial markets are happy with Latvia – the government can borrow at super-low interest rates; even, for now, at negative rates. Again, measures seen as reasonable, well-targeted and temporary should not lead to that much higher borrowing costs for Latvia.

Figure 3: Interest rates on long-term government bonds, Italy and Latvia. Daily rates; 1 January 2020 – 15 March 2020.

Source: Eurostat

But I still think one should be cautious and e.g. look at lessons from a country like Italy. A country that is severely hit by the virus, that already has a somewhat high budget deficit (Figure 1) and thus less room for maneuver as well as a mountain of public debt to service (Figure 2). Financial markets – already in stress and easily spooked responded by demanding higher interest rates to lend to Italy, see Figure 3. OK, the ECB now stands ready with massive support (again, again…), but still…

It is obviously very important nothing similar happens to Latvia but the healthy conditions of the macro numbers presented above should help to avoid this. Latvia looks quite well-prepared, economically as well as politically – but it will be nasty to look at GDP and unemployment figures in the months to come.

 

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and Vice-Chairman of the Fiscal Discipline Council of Latvia.

Points of view expressed here are not necessarily those of the Fiscal Discipline Council.