I. Introduction

1. The strong economic expansion that began in 1996 and accelerated in the following year reversed sharply in mid-1998 as a result of both external and domestic shocks. The initial expansion was fueled by accelerating domestic private and public demand, as well as growing demand for Latvia’s output in both new, mostly EU, and the traditional, CIS markets. Domestic consumer and investment demand were supported by growing real incomes and tax revenues and pent-up demand carried over from previous years, and reinforced by improving consumer and investor confidence and projections of rising real income in the medium-term. Improved economic performance in the European Union and in Russia and Ukraine increased demand for Latvian exports. Low capital intensive and fast maturing foreign direct investments contributed to increase in productive capacity and competitiveness of Latvia’s manufacturing base. The expansion was easily financed with relatively cheap domestic credit provided by an extremely competitive financial system still relatively free of regulatory restrictions, and foreign direct and portfolio investment inflows.

2. The concurrence of strong external demand, positive domestic factors, and availability of financing did not last beyond mid-1998. The positive external environment changed overnight following the partial default of the Russian Federation government on its debt and the ensuing steep depreciation of the Russian ruble in August 1998. The modest economic slowdown in the EU area in the second half of 1998, economic slowdown in other central European economies, and the direct exposure to the Russian crisis of Latvia’s two Baltic neighbors, Estonia and Lithuania, and other CIS members left large parts of Latvia’s export-oriented producers with few viable alternatives to the Russian market. Sharp contraction in external demand in CIS could not be fully compensated by already declining rate of growth of exports to the EU. As a result of weaker external demand, a number of companies began shedding their labor force, which led to the deterioration in consumer confidence and spending. Lower tax revenues in early 1999 constrained public demand. Also, as expected, the very high credit expansion of 1997–98 resulted in increasing proportion of nonperforming loans. Weaker and less liquid balance sheets forced banks to tighten credit and seek stable, albeit, lower returns in more secure assets, such as government securities. The slowdown in credit expansion was accelerated and deepened by the sizeable losses resulting from banks’ direct exposure to Russian government securities and Latvian companies doing business with Russia.

3. The Russian crisis transformed, what might have been a “soft landing” of an overheating Latvian economy into a deep and full fledged recession. Over the course of three quarters of 1998, Latvia’s economic growth decelerated from a 12-month quarterly growth of almost 9 percent to a 1.9 percent economic contraction in the final quarter of 1998, a reversal of almost 11 percentage points. The crisis, and especially the depreciation of the ruble, and the growing current account deficit also raised questions about Latvia’s competitiveness. Latvia’s firm adherence to a fixed exchange rate regime (with lats pegged to SDR) since 1994 inevitably resulted in some deterioration of competitiveness as domestic inflation in Latvia systematically exceeded inflation rates of its EU partners. Although a number of transition economies experienced even higher inflation rates, few, with the exception of Estonia and Lithuania, maintained fixed exchange rates over the previous five years. Russia, one of the most important partners, depreciated its currency steeply in August 1998, effectively, at least temporarily, pricing most Latvian goods out of its market. The real appreciation of the lats vis-à-vis its trading partners has been partly blamed for the growing current account deficit.

4. The following chapters address in detail three issues that gained prominence during the previous eighteen months in policy analysis in Latvia. Chapter II examines in great detail the economic interrelationship between Latvia and Russia and explains how the dramatic contraction of export markets in the CIS and the geographical proximity of Russia with its resulting links, have had a significant slowing effect on the Latvian economy in general and on selected economic sectors. Chapter III discusses the issue of external competitiveness of the Latvian economy. It provides the results of a comparative study of alternative calculations of real exchange rate indicators and other competitiveness indicators, such as wages and market shares. Chapter IV reviews the developments in Latvia’s financial system during the past four years. A Statistical Appendix is also attached.

5. The three chapters carry a number of messages and lessons. Chapter II argues that, given the dramatic decline in the value of the ruble and other CIS currencies, as well as a pessimistic outlook for growth in these economies, demand from these markets is likely to remain depressed and, therefore, Latvian producers will have to continue restructuring their operations to improve competitiveness and diversify further their trade away from the CIS if they are to remain viable. Even if in the end the impact of the ruble depreciation on competitiveness of Latvian goods in the CIS proves to be temporary, Latvian companies specializing in operations in the CIS may face stronger competition from other transition economies in their fight to preserve what used to be a very profitable, even though volatile, export market. Given the geographic proximity and traditional economic ties between the three Baltic states and the western part of the CIS area, it is quite conceivable that the decline in the share of Latvian exports to Russia would be reversed in the future.

6. Chapter III argues that, on the one hand, although the various calculations of the real exchange rate give a mixed picture, they generally indicate that Latvia has lost some of its external competitiveness. On the other hand, while Latvia’s wages have been converging to their equilibrium level, they remain below them and, therefore, there remains scope for further appreciation. The strong competitive position of Latvia is also evidenced by its ability to increase its exports market share, in particular in the EU. The chapter concludes that the continued maintenance of Latvia’s external competitiveness will be partly dependent on Latvia’s ability to continue to attract foreign direct investment, which in turn will be influenced by its progress in structural reforms and ability to maintain macroeconomic stability.

7. Chapter IV concludes that Russian crisis, which had a significant impact on the Latvian banking system, exposed vulnerabilities that had built up during the expansion period from 1996 and proved more reforms were needed in the aftermath of the 1995 crisis. Much blame for the 1998 banking problems have been placed on banks’ exposure to Russian assets and the regulatory failure, evidenced in criticisms directed at the Bank of Latvia that it should have prevented banks from speculating in high-yielding Russian securities. However, it is clear that poor lending and investment decisions made by bankers themselves were the primary cause of the 1995 and 1998 banking crisis. The shock waves from the Russian crisis most likely only accelerated (and initially deepened) the onset of the banking crisis in a sector dominated by too many weak financial institutions. Even the largest Latvian banks in August 1998 were probably too small to weather successfully the expected volatility of operating in a small and open economy that was so much dependent on the economic fortunes of its neighboring transition economies. Market-driven and, to a large extent, foreign financed consolidation of the banking system is bound to accelerate as stronger institutions take over weaker ones. Increase in foreign participation should bring in new technology and modern banking skills. It is unlikely, however, that any consolidation not accompanied by strengthened supervisory rules can produce a competitive financial system that will completely free itself of the disturbances caused by periodic domestic and external shocks.

8. There is one lesson from the economic developments of the past 18 months that should not be lost in the detailed review of the main conclusions presented in Chapter 2 through 4. To overcome the current crisis and better prepare itself to face future external and internal shocks the Latvian government must continue with its policy of prudent fiscal performance, and go on to complete the ambitious agenda of remaining structural reforms which should aim at integrating the country with the world economy. The ultimate lesson from the reversal of economic fortunes over the past 18 months should be that it is less important how deeply output contracts in response to outside events, and more important how quickly the Latvian enterprises can adjust to the new environment and resume profitable growth.